Ardea Investment Management, a $5 billion Australian-based fixed income boutique, has warned about the possibility of “inflation shock” for big super funds. A paper, published on the eve of Brexit last week, illustrates other dangers on the global stage than the complicated fallout of European disunity.
Ardea, which was formed in a similarly tumultuous time in 2008 by the core of Credit Suisse’s fixed income team based in Sydney, believes investors are facing a new period of volatility in interest-rate-sensitive portfolios, with the March quarter surprise inflation result highlighting the consequences of unexpected changes in inflation.
Tamar Hamlyn, one of the firm’s principals, says: “Market interest rate expectations for the next 12 months changed by nearly 40bps in the space of two weeks, following that result. “This was a large shift in an already-flat interest rate environment, which resulted in substantial volatility in the Australian bond and currency markets,” he says. “This demonstrates the powerful impact of unexpected inflation outcomes on volatility in portfolios, which is amplified in an era of record low interest rates.”
While 2016, both pre-and-post Brexit, is an interesting time for fixed income managers, 2008, when Ardea was born, presented a similarly challenging period from which lessons may be learned. Interest rates initially spiked in February 2008 on the uncertainty and then commenced their gradual decline to zero or, in some cases, negative territory. Australia, thanks to our commodities and the Chinese stimulus, defied gravity for a few years. But now, it seems, the chickens are coming home to roost.
The Ardea paper ‘How Quickly Can you Boil a Frog? The Case for Hedging Inflation Risk Volatility’, argues the relevance of inflation as an input, notwithstanding the apparent benign inflationary world most countries are in. It’s all about expectations.
Hamlyn says: “Anticipation and smart positioning are essential to respond to any sharp unanticipated inflation outcomes. At the moment, inflation insurance is cheap, as inflation expectations are low, and it’s usually a good idea to buy insurance before it is necessary.
“As the March quarter has shown, unexpected inflation shocks can occur and can have a considerable short-term impact on many asset classes, as well as bringing forward the impact of long-term compounding declines in the purchasing power of fixed income streams.”
Ardea is part of the Fidante Partners multi-affiliate firm owned by Challenger. The four co-founders are Kiwis Ben Alexander and Andrew Bartlett and fellow Credit Suisse fixed income managers Hamlyn and Stephen Clout.
The research paper says: “Like the parable of the frog being boiled alive slowly and not noticing until it is too late, we believe inflation presents two core concerns for investors.
The first concern is that inflation is generally positive and compounds through time, even if the rate of change varies. This means that its impact on short term spending power can go unnoticed but over the long term, it has a very significant impact on the purchasing power of investment returns.
“To combat this, Ardea typically has an allocation to securities such as inflation linked bonds whose returns are directly correlated with inflation in all economic conditions, not just those correlated with positive economic growth scenarios.
“The second risk is that sometimes the rate of change can be very sudden, as has occurred recently in Australia and the US. This can have substantial ripple effects on various asset classes as sharp changes in inflation expectations are priced into long-term cash-flow streams and thus the present value of assets.
“Ardea typically responds to this by ensuring we have exposure to instruments with asymmetric payoff profiles that will not detract significantly from their current portfolio performance (limited downside if inflation stays low) but will respond in an outsized fashion if unexpected inflation volatility or upward shocks occur.”
* Greg Bright is publisher of Investor Strategy News (Australia)