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-For the first time in some years, inflation is a looming concern for investors.

-This is being felt in asset pricing, with longer-dated bonds rising higher and more economically-sensitive stocks leading markets higher.

-An inflationary shock looks unlikely, but investors should still be alert to shifting inflation expectations.

Investors have been preoccupied with the impact of the pandemic, but as the economic impact has lessened and recovery builds momentum, they have started to find new concerns. At the top of the list today is inflation. Could the confluence of economic recovery with vast economic stimulus cause a shock?

It is some time since investors have had to worry about inflation. For the past decade, the fear has been deflation, with policymakers struggling to sustain self-sustaining economic growth. This has been reflected in asset pricing, pushing bond yields lower and supporting high growth equities. However, more recently, there has been a shift in thinking, with longer-dated bonds started to rise as investors anticipate higher inflation and - potentially - a rise in interest rates.

Iain Pyle, manager of Shires Income PLC, explains this change of heart: “The pandemic has led to a shock in terms of demand. Central banks created a lot of liquidity, implemented a lot of quantitative easing and put a lot of money into the economy. Combined with the vaccine rollout, the expectation is that we will see a sharp economic recovery this year. People that have saved money will spend it. We have this situation where demand in the economy could come back very strongly and drive inflation going forward.”

While inflation expectations aren’t particularly high relative to history, he adds, investors have come through a period of such low inflation that even a small change is significant.

Regional differences

For the most part, markets are anticipating a short-term hike in inflation, driving by pandemic-related weakness in supply chains and rising demand as economies unlock. The current consensus is that this will ebb in 2022 and beyond as these bottlenecks ease.

That said, there are notable differences across regions. There is notably more pressure in the US, says Amit Moudgil, fixed income specialist: “There have been huge stimulus packages from Trump and now Biden, with more to come. The emphasis has been on recovery and getting the vaccine rolled out. Also, the Federal Reserve has moved towards a ‘flexible average inflation targeting’ regime. This gives it a little bit of scope for the economy to run hot.”

It’s a different picture in Europe, where medium term inflation expectations are only around 1.6%. Moudgil adds: “The initial impact of stimulus programmes in Europe has faded somewhat and there’s been a sluggish rollout of the vaccine. Lockdowns in Europe are likely to last longer and that will affect inflation.” In the UK, realised inflation figures are still relatively low.

Deflation

Many of the deflationary forces that have kept inflation low for many years are still in play. Pyle says: “We’ve had 40 years of low inflation and there are long-term deflationary forces such as ageing populations or efficiency gains from technology that aren’t going to change.”

There are also a number of short-term deflationary forces. He adds: “Unemployment is higher than it has been and is likely to stay high. That puts a lid on real wage growth and creates a barrier to inflation. Oil markets are well-supplied and we expect OPEC to release more oil onto the market as demand comes back. Rapidly rising energy prices look unlikely.”

This leaves a longer-term inflation shock only an outside possibility. Moudgil says that central banks and governments are, for the time being, untroubled. The prevailing view is that inflation will peak fairly soon: “We’ve seen a lot of fiscal stimulus and the monetary side, but there’s a lot of slack there as well.”

That said, there are parts of the market that are subject to higher inflation. Nalaka de Silva, manager of Aberdeen Diversified Income and Growth Trust, says: “Within the basket, it is worth noting that areas such as healthcare costs and college tuition have risen really quickly. Healthcare costs have trebled over the past decade. When we think about the large demographic forces that are going on behind the scenes, the purchasing power for a specific cohort is being squeezed.”

Portfolio protection

As such, even without a potential inflationary shock, investors need to ensure that their portfolio has some protection. De Silva has built protection into asset selection in the Trust: “We want long duration income with inflation characteristics. That means we have a lot of infrastructure in the portfolio, which provides a natural hedge to inflation. It is GDP-led, income generative and the income is naturally linked to the inflation basket.

“We have tilted the portfolio to get more income from private markets, such as private equity. The equity portfolio is tilted to growth and credit is longer duration with more spread baked in. This supports the dividend yield at a level higher than inflation.”

Equities have a natural hedge to inflation, says Pyle, but inflationary considerations will affect the type of sectors that do well. “The ones that do well in inflationary environments are the more commodity-focused ones - metals and mining, autos, chemicals, energy, semiconductors, banks - while stable growth companies such as consumer staples, insurance, healthcare and utilities, tend to underperform.”

For the time being, a significant inflationary shock looks unlikely. However, that doesn’t mean investors can forget about it. Shifting expectations on inflation could still have an impact on asset pricing and therefore on portfolio positioning.

Important information

Risk factors you should consider prior to investing:

-The value of investments and the income from them can fall and investors may get back less than the amount invested.

-Past performance is not a guide to future results.

-Investment in the Company may not be appropriate for investors who plan to withdraw their money within 5 years.

-The Company may borrow to finance further investment (gearing). The use of gearing is likely to lead to volatility in the Net Asset Value (NAV) meaning that any movement in the value of the company’s assets will result in a magnified movement in the NAV.

-The Company may accumulate investment positions which represent more than normal trading volumes which may make it difficult to realise investments and may lead to volatility in the market price of the Company’s shares.

-The Company may charge expenses to capital which may erode the capital value of the investment.

-There is no guarantee that the market price of the Company’s shares will fully reflect their underlying Net Asset Value.

-As with all stock exchange investments the value of the Company’s shares purchased will immediately fall by the difference between the buying and selling prices, the bid-offer spread. If trading volumes fall, the bid-offer spread can widen.

-Certain trusts may seek to invest in higher yielding securities such as bonds, which are subject to credit risk, market price risk and interest rate risk. Unlike income from a single bond, the level of income from an investment trust is not fixed and may fluctuate.

-With funds investing in bonds there is a risk that interest rate fluctuations could affect the capital value of investments. Where long term interest rates rise, the capital value of shares is likely to fall, and vice versa. In addition to the interest rate risk, bond investments are also exposed to credit risk reflecting the ability of the borrower (i.e. bond issuer) to meet its obligations (i.e. pay the interest on a bond and return the capital on the redemption date). The risk of this happening is usually higher with bonds classified as ‘subinvestment grade’. These may produce a higher level of income but at a higher risk than investments in ‘investment grade’ bonds. In turn, this may have an adverse impact on funds that invest in such bonds.

-Yields are estimated figures and may fluctuate, there are no guarantees that future dividends will match or exceed historic dividends and certain investors may be subject to further tax on dividends.

-Derivatives may be used, subject to restrictions set out for the Company, in order to manage risk and generate income. The market in derivatives can be volatile and there is a higher than average risk of loss.

-The Company may invest in alternative investments (including direct lending, commercial property, renewable energy and mortgage strategies). Such investments may be relatively illiquid and it may be difficult for the Company to realise these investments over a short time period, which may make it difficult to realise investments and may lead to volatility in the market price of the Company’s shares.

-Investing globally can bring additional returns and diversify risk. However, currency exchange rate fluctuations may have a positive or negative impact on the value of investments.

Other important information: Issued by Aberdeen Asset Managers Limited which is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Registered Office: 10 Queen’s Terrace, Aberdeen AB10 1XL. Registered in Scotland No. 108419. An investment trust should be considered only as part of a balanced portfolio. Under no circumstances should this information be considered as an offer or solicitation to deal in investments.

For more information, please visit our websites:

Shires Income PLC

Aberdeen Diversified Income and Growth Trust plc

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Issue Date: 18 Jun 2021