Portfolio Adviser • Portfolio Adviser Magazine December 2021 • MPI

Caution is being exercised across all sterling mandates as concerns over inflation, central bank policy and China’s new agenda is showing itself in investment decisions

Returns on sterling mandates across all three risk categories were muted over the third quarter as most of the gains made in July and August were wiped out by drawdowns during September. This was mainly due to concerns over the US debt limits and the default by Evergrande in China.

As such, low-risk mandates averaged 0.43% over the quarter, while medium risk produced 0.84% and higher risk 1.25%. Our survey of 37 investment managers shows that sentiment became more prudent, with around one-third of managers saying they became increasingly cautious over the quarter.

Our poll reveals that inflation expectation and central bank policy error were cited as the two biggest areas of concern. However, with yields at all-time lows, traditional inflation hedges are looking increasingly risky.

Cerno Capital portfolio manager Michael Flitton says: “People are interested in inflation-linked bonds and we have owned them in the past but, in our view, while they do offer some protection against inflation, those assets are more sensitive to interest rates than changes to inflation expectations.”

Managers have been turning increasingly to companies that can pass costs on or that own real assets with CPI-linked cashflows, as Flitton explains.

“We believe quality companies that exhibit pricing power are the companies to own as these offer the best hedge against inflation over the long term,” he says

“Our studies show that these types of companies tend to outperform the market during periods of inflation.”

He adds: “Given equities will have headwinds, we increasingly look to companies that own real, income-producing assets such as real estate, infrastructure, or alternatives such as music royalties. For example we recently participated in the IPO of Life Science Reit, which invests in life sciences properties in the golden triangle in the UK.”

Central banks have been signalling rate increases for next year, although the pace of fiscal tightening is unlikely to be uniform. This has prompted several managers to trim their dollar and euro exposures in sterling mandates.

“In multi-asset portfolios we do part hedge back to GBP, and that has been increased to 60% in the past few months,” says Flitton. “In our view there are specific problems with the UK economy that will lead to greater pressure on UK interest rates than other areas, and we would expect that to be supportive for the currency.”

Markets were also spooked by a flurry of new regulations recently introduced by China which, on the face of it, seemed to signal a more hostile position on private capital. However, as Flitton argues, this should be viewed in the context of China’s own ‘levelling-up’ agenda

“The issue with inequality is that it disincentivises people to have children which creates a whole lot of problems. The catalyst this year was the census which shows a material decline in the birth rate. The Chinese are good students of history, and they know this is what bedevilled Japan and created a lot of problems for west Germany until unification

“So that is why the Chinese are focusing on inequality. Where private capital runs counter to the need to battle inequality, regulations are clearly in the pipeline around those areas.”

Unlike the west, where there is more consultation on new regulations, these announcements came as a shock. As a result, the narrative develops that China is against private capital, which worries markets.

But Flitton counters: “The government is well aware of the contribution of private capital, which is responsible for 70% of technology investment in China and 80% of urban employment. Also, recently we’ve seen this regulatory flurry is dissipating.”

Another event that caused markets to pause was the collapse of real estate giant Evergrande, but managers generally seem sanguine about broader contagion. As Flitton explains, in an economy where the government still has significant economic controls, this may have been more a shot across the bows.

“Historically, getting ‘too big to fail’ was the key goal of many Chinese companies. If you can get big enough, quickly enough, you preserve your capital knowing the government will step in if things go wrong.

“It seems the Communist Party has had enough of these companies, however, particularly in the construction and real estate sector. So to remove that moral hazard, you have to let companies fail. Unfortunately, as there is so much wealth dependant on this sector, when you allow companies to fail, you are treading a very fine line".

Despite these recent concerns, China remains an important market and one that is becoming increasingly di£ cult to ignore. The days where China produced cheap, lower-quality goods for consumption in the west are rapidly receding

Flitton says: “It’s still the perception that companies in those regions, particularly China, produce lower-quality products. However, the reality is they have been moving up the value chain, and now create similar value products at a lower cost.

“For example, developer of medical devices Mindray has penetrated all of the top-20 hospitals in the UK and the US. This difference between perception and reality creates an opportunity for investors.”