Inflation is, unsurprisingly, emerging as a key concern for allocators in 2023. Recent data certainly suggests that inflation may not prove as transient as many analysts had predicted. Consequently, many global hedge-fund managers are preparing for persistent inflation this year and are seeking exposure to assets that perform well in such an environment.
Inflation protection a key concern
Even the IMF underestimates inflation
It’s not often the International Monetary Fund (IMF) admits it was wrong. But in March, Christopher Koch and Dia Noureldin, economists in the organisation’s research department, conceded that ‘the rapid rise and persistence of the current wave of global inflation eluded most professional forecasters, including us at the International Monetary Fund’. 1
Hedge funds have also been caught out. Many spent early January racing to cover Treasury shorts on waning confidence that the series of interest-rate hikes in 2022 made by the Federal Reserve (the Fed) would reverse in 2023 as inflation ebbed. Indeed, ever-higher rate cuts seemed on the cards as the global economy teetered on the brink of recession. Inflation has persistently surprised on the upside around the globe this year, and central-bank officials are arguing the hiking cycle is far from over.
Unsurprisingly, against this background, many global hedge-fund managers are preparing for persistent inflation and are seeking exposure to assets that perform well in such an environment, according to a recent Reuters survey. There are three favoured strategies: exposure to inflation-linked bonds to shield against price rises; selective exposure to corporate credit, as higher interest rates restore some differentiation in company bond spreads; and exposure to commodities. Indeed, a majority of the ten global asset and hedge-fund managers surveyed by Reuters said that commodities are undervalued and should thrive as global inflation stays elevated in 2023. Meanwhile, they’re seeking to avoid or short-sell equities. 2
In February, five prominent hedge funds shared five ideas using five different asset classes to profit from inflation ‘so pugnacious it might force the Fed to keep interest rates higher for longer’, according to Reuters. 3 The news agency shared the results following the news that the consumer price index surged by 0.5% from December to January – five times the increase seen in the previous month. 4
Chairman and founder of Graham Capital Ken Tropin told Reuters that if interest rates remain high, then long-dated government bonds such as ten-year US Treasuries will be too ‘expensive’ compared with two-year notes as they yield so much less. The US yield curve, as measured by the gap between two- and ten-year yields, is at its most inverted in decades – a sign of recession risk. Reuters quoted Tropin as saying, ‘If you think the yield curve is going to normalise, that’s how you execute that trade.’
Spread between US near and long term rates
Colin Lancaster, global head of discretionary macro and fixed income at Schonfeld, told Reuters he favours selling interest-rate futures based on the cost of borrowing at the Secured Overnight Financing Rate (SOFR) – a benchmark interest rate.
Meanwhile, Brian Hessel, chief risk officer and chief operating officer (COO) at Global Credit Advisers, believes – according to Reuters – ‘the pricing in of higher interest rates hasn’t reached the riskiest parts of the corporate bond market’. So he favours taking positions on single-name, high-yield credits or the indices that track the performance of these companies.
Doug King, chief executive officer (CEO) at RCMA Asset Management, told Reuters that buying long-dated US natural gas futures ‘in an inflationary cost/wage environment looks compelling’. King believes that, in the next few years, the US will increase its output of natural gas significantly to meet domestic and global demand.
In late February, CEO of Man Group Luke Ellis told the Financial Times that inflation will remain high because of strong wage growth. He explained:
‘The base effects are running out and we still have very significant wage inflation. It’s not squeezing services [sector] wage inflation, and services is such a big part of the economy’. You can’t get consistently to [a] 2 per cent [inflation target] when you have 6 to 7 per cent [sic] wage inflation’. 5
Ellis added that he expected volatility to remain high as investors try to gauge the outlook for inflation and borrowing costs. That should provide fertile ground for hedge funds.
Finally, Bloomberg recently reported on the results of a study by financial historians Elroy Dimson, a professor at Cambridge University, and Paul Marsh and Mike Staunton of the London Business School. The study, which covered 122 years of financial history, suggested that those hedge funds that are using commodities to shield investors against inflation certainly have the past on their side.
The best assets for protecting against inflation
1 https://www.imf.org/en/Publications/fandd/issues/2023/03/how-we-missed-the-recent-inflation-surge-koch-noureldin
2 https://www.reuters.com/markets/global-hedge-funds-plan-2023-around-inflation-risk-2023-01-04/
3 https://www.reuters.com/markets/how-big-hedge-funds-would-trade-sticky-inflation-2023-02-16/
4 https://apnews.com/article/inflation-economy-business-9b044c8ada5aa538d539237be1da9d14
5 https://www.ft.com/content/a1ce3459-08bb-476a-b422-aab336ae28c5
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