Investment

Inflation – it’s only going up says family office CIO; buy protection now with inflation swaps

Robert Sears saw how boom can suddenly turn to bust when he was associate at investment bank Merrill Lynch, either side of the great financial crisis of 2008.

As chief investment officer at Capital Generation, a multi-family office backed by the Said family, he believes family offices should buy protection now, against an abrupt hike in inflation over the medium term. And, right now, the price is right. 

The annual rate of US inflation has just hit 7%, the fastest rise for nearly 40 years, following post-Covid price hikes for rents, energy, pay, cars and supply chains. The market view is that recent price increases will drop out of the reckoning quite quickly.  The Federal Reserve is expected to start hiking rates in March and ease down its purchase of bonds to meet market expectations without raising rates too high, for now.

But Sears says investors should look beyond short-term noise: “I’m less interested in short-term supply shocks than whether it will lead to longer-term damage. And it does look like there has been some.”

He points to populism fuelled by inequality which seeks redress by demands for higher and higher pay reinforced by a tight labour market where immigration is being kept under control. Companies will also face an ongoing cost from bringing manufacturing onshore, as a result of tension with China. The workforce mood is already tense. Jamie Dimon, chief executive of JP Morgan, says he has never seen such powerful pressure on wages.

Demographics will further increase the cost of labour as workforces retire, even in China. Dealing with climate change is clearly inflationary, as illustrated by the squeeze on gas prices. And the next generation coming to political power could be prepared to print more money using a magic money tree to meet government outgoings because they have not experienced the inflationary consequences.

All these could be secular changes and Sears believes a new regime has already begun: “We’ve already had a situation where voters were happy to endorse fiscal expansion due to Covid-19, leaving monetary policy way behind the curve.”

He explains central bank stimulus has produced a mountain of debt which has pushed up the value of assets, as opposed to the cost of living, which could enter a sharp, deflationary, decline if the Fed pushes interest rates too high. 

“The authorities don’t want blood on the streets, so they could hold back on the measures needed to contain inflation. And if you have a debt problem, do they really want to risk austerity? Do they want a deflationary wave which collapses the asset bubble?”

The Fed could end up letting inflation rise in the medium term to inflate away debt, rather than resorting to politically unpopular taxation to balance the books. It’s a difficult balance, making a hedge against the probability of medium-term inflation look attractive.

Protection is cheap because the price of inflation swaps is based on the market’s belief short-term inflation will fall back: “Most portfolios are still predicated on what has worked over the last forty years.” Faith in the short term may be wrong, but that’s the way assets are being priced.

Family offices buy protection using interest rate swaps, where a bank would agree to pay a client returns achieved over market’s expectation of consumer price inflation at 2.5% over five years, based on the price of inflation-linked bonds. To protect its position, a bank supplying a swap would itself hedge the position in the market. 

The total cost of insurance over five years would be nearly 13%, but client gains over the period could be multiple higher if, or when, inflation gets established. If annual CPI were to jump to 15%, clients would see a net profit of 12.5% in one year.

As well as inflation swaps, CapGen has suggested that its clients should use put and call options to protect their portfolios. It also likes value strategies, long/short hedge funds, gold and commodities, balanced by put and call options. It has increased its bias towards active managers believing them better placed to deal with market stress than passive funds.

 

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