Ep 35. The Long-Short | Inflation is rising. Here is what you need to know

Published: 13 July 2022

The Long-Short is a podcast by the Alternative Investment Management Association, focusing on the very latest insights on hedge funds and private credit.

Each episode will examine topical areas of interest from across the alternative investment universe with news, views and analysis delivered by AIMA’s global team, as well as a host of industry experts.

With estimated inflation in the US and UK now above predicted levels and nearing double digits, The Long-Short this week revisits a conversation with Henry Neville, an investment analyst at Man Group, who discussed what higher inflation means for retail and institutional investors and what investment strategies usually work best in this environment.

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Hosts: Tom Kehoe, AIMA; Drew Nicol, AIMA

Guest: Henry Nevile, Investment Analyst at Man Group

Interlude: Lorna Barnard; AIMA

[Intro] Tom Kehoe, AIMA  00:05

Hello and welcome to The Long-Short, a new podcast brought to you by AIMA, the Alternative Investment Management Association, focusing on the very latest insights on hedge funds and private credit. My name is Tom Kehoe. AIMA is the global representative of the Alternative Investment Industry with around 2,000 corporate members spread across 60 countries. Of these are fund manager members account for approximately two and a half trillion dollars in hedge fund and private credit assets. Each weekly episode of The Long-Short will examine topical areas of interest from across the alternative investment universe. News, views and analysis delivered by AIMA’s global team, as well as a host of industry experts. So, whether you're a hedge fund or private credit industry veteran, a student of the industry, or just someone interested in learning more about hedge funds and private credit, this podcast will be your ideal companion to help navigate you through the long and short of this fascinating industry.

Tom Kehoe, AIMA 

Hello and welcome to episode 35 of The Long-Short, a special repost of episode 18. Prices are continuing to rise at their fastest rate in well over 40 years. With food costs and the cost of energy, traditionally the biggest drivers of inflation, continuing to increase.

Drew Nicol, AIMA  01:15

Meanwhile, worry about inflation has topped Ipsos's 'What Worries the World' survey for the third month in a row - as concerns about inflation has risen in the chart for 11 straight months. Inflation levels are now around 9% in both the UK and the US, with the Eurozone not far behind, and the latest figures pointing to inflation rates being approximately 8% across the region.

Tom Kehoe, AIMA  01:38

And if that is not alarming enough, most commentators are saying that a peaking inflation has not yet been reached, with some forecasts pointing to double digit inflation by the fourth quarter of this year, with the cost of living becoming an increasing burden.

Drew Nicol, AIMA  01:51

With this in mind, we at The Long-Short thought it would be prudent to re-visit our discussion on the topic with Henry Neville, an investment analyst at Man Group, who discussed what higher inflation means for retail and institutional investors, and what investment strategies usually work best in this environment.

Tom Kehoe, AIMA  02:07

So as always, please like, rate and share our podcast, now available on Apple, Google, Spotify, and Amazon Music. Thanks for listening. 

Tom Kehoe, AIMA 

Inflation levels being above a few percentage points has not been a real concern in well over 30 years. It had been assumed that high inflation was a thing of the past, yet it came back with a vengeance over the past year and inflation rates are now at 7.5% in the US and expected to reach similar levels in the UK later this spring. Now economists are debating what to do about it.

Drew Nicol, AIMA  02:44

And joining us today to discuss all of this is one of Mann Group's esteemed investment analysts, Henry Neville. Henry, welcome to The Long-Short.

Henry Neville, Investment Analyst at Man Group  02:51

Thanks very much Drew and Tom, great to be here.

Drew Nicol, AIMA  02:51

So, just to take the UK, as an example, the Bank of England aims to keep inflation at around 2%. And in fact, has to write a letter to the Chancellor of the Exchequer, once it goes over that threshold. We now are in a situation where it is running at around 4%, with many forecasters predicting it to go somewhat higher. Could you provide us with some background on what's behind the current inflation spike, and what global economies are experiencing now?

Henry Neville, Investment Analyst at Man Group  03:28

Yeah, it's a complex issue, of course, but I think there are three key drivers to the situation we find ourselves in today. The first is a pandemic effect. When I say a pandemic effect, I don't mean just a March 2020 thing, this effect has gone on for much longer. That is that when the pandemic hit, a lot of supply in various industries was shut down almost overnight. Either companies were responding to the pandemic or mandated by governments to shut down supply chains in the whole lockdown scenario. Demand after the pandemic came back, I think faster than almost anyone had predicted. And the thing about modern supply chains is they're quite complicated, so semiconductors being the clear runaway example, if you shut down a semiconductor plant or fab, as it's called, turning it back on again, it's not just a matter of ordering a pint at your local pub, it takes quite a long time to do. So as demand came back much faster than people were expecting, the supply side of the economy couldn't respond quickly enough to that, and that led to inflationary pressure. Second, there's been a monetary impact.

The monetary response to the GFC, as we all know by now, though many predicted it, did not cause inflation and that's because central bank reserves are not money. It's a common misconception. So, although central bank reserves, because of QE programs, rose really vertiginously, that didn't feed through into real money. This time around, as we all know, governments have been putting money directly into people's pockets, stimulus checks in the US, but similar pieces of policy around the world. Just to give you some numbers on that, in the US today, if you look at M2 numbers, there are about US$22 trillion in the world today that have ever been created, 7 trillion of those have come into being since 2020. So, we've got about a third of dollars ever created happening since the beginning of 2020. That has had a very real impact. And finally, there are just various structural forces, which have been bubbling away in the background really for many years, but have come to the fore recently, given the recent shocks. And a few different things we could talk about, if I limit myself to just one, the just-in-time supply chains, which we've seen being developed over many decades recently, have been really found wanting through the pandemic. And we're moving from just-in-time supply chains to just-in-case supply chain. So just yesterday, for instance, I noticed Porsche and BMW had to close temporarily 4 plants across Europe, due to one of their suppliers in Ukraine, which makes the plastic harnesses which holds the electric wiring in their cars, having to stop production due to Russia's invasion. So just that tiny component of the car goes, and the whole system has to shut down because there's so little room for error baked into those supply chains. So, that's been a long-term structural force, and it's really been altered by recent events, and that's caused inflationary pressure.

Tom Kehoe, AIMA  07:02

Definitely thinking about just the everyday person and how it impacts them, higher inflation levels that is, I note that myself, this week, I got notice from my gas supplier that my gas and electric prices will double over the coming year. And Henry you've talked about car prices, new car prices, and indeed secondhand car prices. But how does higher inflation impact people's everyday lives? And what is that impact? We've talked about gas supply talked about car prices, but other impacts.

Henry Neville, Investment Analyst at Man Group  07:41

So, the bottom line is it impacts people very negatively. Three channels in which it does that, the first is what Fisher, the great 1920s US economist, termed the Money illusion. That is that there's quite a delay between people realizing that prices around them are rising, and them asking for wage increases, then there's actually a further delay between them asking companies giving them those wage increases, or not. So, in real terms, people's wages always fall, often throughout an inflationary regime, but certainly towards the beginning of it. And that means standards of living decrease. And secondly, ultimately, it affects people's nominal livelihoods as well as their real livelihoods, because recessions almost always follow inflationary regimes. So, in our work, we've looked at the eight inflationary regimes before the one we believe we're currently in, in the US over the past 100 years. If we take the most recent five of those, in every single instance, a recession has followed pretty much immediately from the inflation regime, often because the central banks, in order to combat that inflation regime, have to tighten monetary policy quite dramatically. So, unemployment rates rise, and that affects people badly. And third and finally, doesn't always happen, but quite often, inflationary regimes affect people negatively geopolitically. And if we think about what inflation is at its most basic level the problem of too much money chasing too few resources, and that can have an outworking in rising prices, but it can also have an outworking in increased strife. You often get wars, and other forms of strife, around inflationary regimes and indeed currently with the tragic situation of Russia and Ukraine. It's not explicitly a fight over resources, but it is hard not to see Russia's timing, as coinciding opportunistically, from their perspective, with the rising gas prices which mean that Europe's response is more blunted than it could otherwise be.

Drew Nicol, AIMA  09:51

Yes, and its incredibly complex situation that we may touch upon as we go through, but just keeping this in the realm of the everyday person, you mentioned that there's somewhat of a delay in when you see these prices going up, in terms of the weekly shopping, we've already mentioned energy prices. Where can people look really in terms of consumer prices to note these upticks? Where does it happen first?

Henry Neville, Investment Analyst at Man Group  10:25

So, a few areas we're looking at, I'll give you three areas we're looking at where we're seeing particular pressure. One is in goods. Now, for a lot of people, the narrative goes that okay, 2021 saw huge upward price pressure on goods, therefore, we must have some sort of recovery through 2022. And, what's interesting to us is we're not seeing that yet at all. And with a particular category, which we are watching is clothing, or apparel, as our American friends call it. Now, what's interesting about clothing is there is a very strong seasonal pattern to it. So almost always in January, clothing prices in America, and over here in the UK, fall. That's because of course, after Christmas, all the retailers they want to get rid of excess stock, they've put everything on sale. So, on average in America, across the last 100 years of data, clothing prices month on month, fall 1.1% through January, this January, we actually saw a 2.5% increase in those clothing prices. And Man Group listening to company earnings calls, a lot of the big clothing retailers, we're hearing them talk about further price rises to come, particularly driven by freight and labor costs. So, that narrative of goods prices rolling over, we're not yet seeing and that's worrying. That's one of the key buttresses to the transitory for inflation argument. Second really important thing is shelter. It's important because it's a massive part of people's consumption. So, in the US it's about a third of the CPI basket. And, it also tends to turbocharge wage price spirals, because your rental payments, your mortgage payments, are a significant portion of most people's outgoings. So, if they start feeling pain there, it's a catalyst for them to start demanding wage rises. Now, we are starting to see movements in this era. So, in the US shelter is up about 4% year over year, that has moved upwards. And that is quite high by historic standards. But it could go so much higher, so we watch a number of indicators.

For instance, Zelos new rental agreements metric is up 16% year over year, now we wouldn't expect the rental component of CPI to follow that exactly, because of course this is looking at new rental agreements, whereas CPI is looking at shelter costs across the whole economy. But we would expect some of those new agreements to start feeding through. And we're already seen price pressure, we could see more. And third, and finally, energy prices. We're all aware, as you reference Tom, energy prices have moved up significantly, in the US energy prices are up 30% year over year. We're interested in this because a lot of people have similar arguments for goods here. A lot of people say "oh, well, oils, 110, or whatever it is now, so surely it can't go that much higher, because it was you know, last peak was 120". But we do just note that if we just literally apply CPI inflation to those 2012 highs through to today, we get to an oil price of 170, so up another 50%. Now, that's not our base case. But it's we don't think it's accurate to say "oh, well, we're close to the peak in 2012, and therefore it can't go much higher". There is a pathway whereby it can get worse, especially given the situation with Russia.

Tom Kehoe, AIMA  14:02

Yes, I did read in the Financial Times today that commodity prices were at record highs since I think it was 2008. That oil price 170 target, which is quite worrying. When I think about the how wages are keeping up with inflation, you know, is average wage growth keeping up with inflation levels?

Henry Neville, Investment Analyst at Man Group  14:24

Again, there's pretty short answer to that, which is no, absolutely not. So just putting some numbers on that, in the US. wages have risen about 5% over the last 12 months, inflation has been 7.5%, so the average worker in the US has experienced a 2.5% pay cut in real terms. In the UK, a bit less but similar pattern, wages up 4%, inflation up 5.5%, so 1.5% pay cut in real terms. Let's make no mistake about this, people's standards of living are falling through this current inflation regime. And that's really important because even though wages have been pushing higher in nominal terms, and impacting headline inflation readings, they could go a lot further because the question you asked going into the midterms in the US and various elections in Europe is, are politicians going to stand for this sort of decline in people's standards of living? My hunch is no. And that could be a major source of further inflationary pressure going forward.

Drew Nicol, AIMA  15:27

We've successfully outlined the problem, buying power is down, costs up across the board. So, let's talk about remedies from a retail perspective point of view, where should people really be putting their money during these periods of higher inflation?

Henry Neville, Investment Analyst at Man Group  15:46

Okay, so I'll have to disappoint you a little bit here, because I'll get in trouble with my compliance department if I start giving investment advice. So, I'm not going to do that. But all I can do is tell you what has factually performed well historically, in inflationary regimes. Now, as I say, we wrote this big paper with Professor Campbell Harvey, a storied academic out in America, on historic inflation regimes looking at the past 100 years across the US, UK and Japan. And had a number of findings, but I'll just point to three things that we found have consistently worked really well. And the first is commodities. In a way you would expect that because commodities go into the goods that make up the CPI basket, but the extent of that positive performance did surprise us. So, in the eight US inflation regimes, commodities in aggregate, so this is everything from metals to energies to wheat, etc. run at a 14% real CAGR adjusting for inflation, with 100% hit rate. Now within commodities, industrials and energies segments performed best, and anything you can eat for agricultural and livestock, etc. Still good, but slightly worse, and that we think is politicians learning the lesson from Marie Antoinette, don't mess with food prices, if you want to keep your head Metaphorically speaking, we hope. Second thing, again, kind of obvious, but good to have the numbers on it, inflation protected bonds also perform pretty well. I mean, they're not going to knock the lights up, but they're going to give you about 2% real annualized (growth). We do need to make the point this time around, though, that tenure tips yield is deeply negative as a starting point in this inflationary regime which was not the case historically. So, we just do need to adjust for that in our thinking, will it provide the same level of protection today as it has historically. And finally, is trend strategies across all segments of the market. So, we constructed a trend strategy, which goes across bonds, FX, equities and commodities at a 15% vol, so quite high volatility, that gives you a real CAGR of 25%. Again, with 100%, positive hit rate across the eight regimes we identified in the US. And the qualitative rationale, we think behind those empirical results for trend, because I know you'll probably be thinking, "you would say that you're Man Group, you know, you love trends, the man with a hammer, every problem looks like a nail".

But it does have a qualitative backing, as well as empirical evidence, which is that we find that in inflation regime, it is a volatile time for anyone at one security and one asset class individually, but the patterns that we see in an inflation regime do tend to persist. So, for instance, seeing within commodities, seeing industrial metals, outperforming agricultural commodities, there tends to be not much volatility in terms of that relationship moving through the inflation regime, and inflation regimes tend to be relatively long, so almost two years on average, and most trend strategies, obviously, look back is 12 months or so. There's that time for those patterns to emerge. So, those are three things which historically, have performed relatively well in inflationary regimes.,

Tom Kehoe, AIMA  19:32

At the risk of putting words into your mouth, Henry then, you've mentioned commodities, and trends strategies. So, is it fair to say then, allocating to alternative investments if you're an institutional investor, can help to counter higher levels of inflation?

Henry Neville, Investment Analyst at Man Group  19:49

Yeah, again, provided I'm not giving investment advice, but on alternative strategies historically, I think it very much depends what sort of alternative strategy you're thinking about. First thing I'd say, as I've just mentioned, commodities and trend, those two alternative strategies, which have done really well historically. Real estate, obviously another big category within the alternative universe. And interestingly, we've found it doesn't work as well, as one might expect, certainly residential real estate in this inflation regime has been very strong both in the US and the UK. Historically, it's a little bit of a ho hum in in real terms. US residential real estate across inflationary regimes was a slight negative, in the UK is slight positive. In Japan, it was a big positive, but it's biased by inflation regimes in the 1980s, where of course, Japan was going through a massive real estate boom, and we all know how that ended. The important thing to realize with real estate is, although it benefits from being a tangible asset, which is a strong quality in an inflationary regime, it does have gearing to the cycle, because most people buy residential real estate through mortgages, if rates are rising, mortgages become more expensive and then becomes less and less appealing investment decision for people.

Also, recessions mean defaults are going to rise. So, there are two effects there. A third kind of category we looked at, you might think this is a bit too zany, stop me if so, but kind of the really esoteric end of the alternative spectrum, so things like art, wine, stamps, collectible type categories, all tend to work. Over the last 100 years and the eight US inflationary regimes, art does plus 7% real CAGR, wine does plus 5%, and stamps do plus 9%. So, wine a little bit less than art and stamps, because it's got the added benefit that if it all goes wrong, you can always drink it.

Drew Nicol, AIMA  22:01

Well, that's very good news, because my uncle is actually an avid stamp collector, and he has recently dedicated a second room in his house to stamps, I found out the other day. But it does seem to be that the old alts are in fashion again.

Henry Neville, Investment Analyst at Man Group  22:19

There is of course, I mean, on those more recent Tarik types of markets, there are other costs, you've got to consider its storage cost, insurance, and they're not liquid markets either.

Drew Nicol, AIMA  22:34

The cost of dedicating two rooms in your house to stamps...

Tom Kehoe, AIMA  22:40

And what about hedge funds? I mean, you've talked about the strategies. But what I'm reading about Henry is that investors are looking to hedge funds, and different types of strategies that are an offer from hedge funds to help navigate the higher inflationary period. We look at performance of hedge funds, albeit it's only one month in so far, but numbers for February suggests that hedge funds have done quite well. It's not just a higher inflationary environment we are working in as well. We are also, sadly, working through a war period as well. But looking at just the high inflation period, historically, have hedge funds done well? An investor that is allocated to hedge funds, have they managed their portfolio well?

Henry Neville, Investment Analyst at Man Group  23:33

I mean, the hedge funds specifically, the answer is, we don't really know because the data, the HFRX indices, they just don't go back far enough to know when the peer group has performed well or badly given, as you say, we haven't had many inflation regimes in recent history. What we can comment on is how there is long-short equity strategies, which have formed within those inflation regimes, which does give us some clues as long-short equity, bread and butter for many hedge funds. If I just focus on three areas. The first is cross sectional momentum. Here we see a very similarly positive effect as we did for trend on a cross-asset basis. So cross sectional momentum in US equities does plus 8% real annualized in inflationary regimes. And again, we think there's a similar quality backing here, because we see through inflation regimes, the companies that perform well keep performing well, and companies that perform badly keep performing badly. So, for instance, gold miners tend to do really well in inflation regimes, and software companies tend to do pretty badly, and that effect tends to be consistent through the regime, so benefits, cross sectional momentum type strategies. Second is size as factor, your large-long caps, short- small caps, that's a good place to be, or has been a good place to be historically. The logic behind that is if you go back to your economics 101, costs of inflation remember a number of different things, but for instance, menu costs, which is the cost if prices are moving much more, you have to reprint and as your restaurant reprint the menus more often. And bigger companies have an economies of scale benefit, whereby they've got the infrastructure, such that they can respond better to those costs than smaller companies. And the final thing I would point to is on value strategies, so value long-short-long cheap companies, short expensive companies.

That's a strategy which there's a lot of anecdotes and rhetoric about how that should perform really well in an inflation regime. And we would get logic because a low PE stock is essentially a short duration stock, and duration is bad in inflation, because you're locking yourself in to a nominal payment for longer, which is going to be deflated by that inflation. But also, we find that it's actually more like zero through an inflation regime. That's because there's a second impact of value, which is gearing to the cycle. You think value companies are often companies which do well in a cyclical upturn. And the market we think does start to look forward to the eventual negative repercussions of the inflation regime, which as I've already mentioned, often involve a recession towards the end of it.

[Interlude] Lorna Barnard, AIMA 26:50

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Drew Nicol, AIMA  27:36

And my ears just prick then because you mentioned gold, which is a perfect segway for my question which I'm most keen to ask you, which is around this conversation that has been going on for some years now about how crypto assets are being touted as sort of the new inflation hedge, the new digital gold. And that argument seems to have some merit in some circles in prior years, but now the rubber meets the road. And so far, crypto assets have not performed comparative to gold, so far this year at least. Can you help me understand what is going on here?

Henry Neville, Investment Analyst at Man Group  28:22

Yeah, so we too, are interested in this whole debate around is Bitcoin an inflationary hedge? The short answer is we don't know, we've don't enough data, we have about 10 years reliable data with Bitcoin. In our work, we think there has been zero inflation regimes in the US in that time. We can say three things though. The first is that in this inflation regime, which we date from the start of March last year, gold hasn't really worked either, certainly. It's just starting to work recently, but it hasn't been consistent with what we've seen historically. So, historically, gold has been plus 13% real CAGR, and in this regime thus far, it's done about plus 4%. And that's only because of the recent rally in gold markets. So it could be that Bitcoin, and other crypto assets, on some extent, are stealing some of gold's punch given how much chatter there is around bitcoin as a digital gold. I personally am not so convinced by that for two reasons. First, Bitcoin also has performed pretty poorly in this inflation regime. In real terms, it's about minus 16% annualised. So, if it is an inflation hedge thus far, it's not working out well. And secondly, we're very data dependent, and there is a credible pathway whereby, you know the situation in Russia calms down, the oil deal with Iran, supply chains come back online faster than people are expecting, and you know inflation really goes away. That's a credible argument to make. So, with an inflation hedge, what you want is something which isn't going to kill you if inflation doesn't happen, or moderates significantly, and with Bitcoin you've got zero carry and volatility about 100%. So, there are many good reasons, I think, to hold Bitcoin as there is evidence that can act as a portfolio diversifier. But personally, I don't think an inflation hedge vehicle is one of those reasons.

Tom Kehoe, AIMA  30:44

How long do you expect this period of higher inflation to continue? I mean, we have, as mentioned this ongoing crisis in Ukraine, we've talked about oil prices being at $116 per barrel, and your forecasts are potentially could go much higher, you know, and mentioning also that this move is likely reflected even higher food prices is making the cost of living even higher, equity markets are being challenged. Normally in higher periods of inflation, you have central banks coming in and taking action, but do you think that they will do so? How long do you think this is likely to continue?

Henry Neville, Investment Analyst at Man Group  31:27

To take the first part of your question, first, we think that this inflation regime is going to be a lot more persistent than the market is currently pricing for. So, our model suggests to us, headline CPI will be 5.7% over the next 12 months. So clearly, that is a rollover from the current rates of 7.5%, but not nearly as much for rollover, as the market is expecting. Just to give you some numbers on that, if you look at the kind of range of other forward pricing indicators, so surveys, derivative markets, and so forth, they range over the next 12 months between 1.8% and 6%. So, our models are right at the top end of that range. And to take the second part of your question. Yes, I think they will continue, the central banks will continue, certainly in America, to tighten as expected, largely because I think they will have to. So, even if the Russia situation resolves faster than expected, I still think you'd go back to an environment where inflation is a concern. We've got to remember inflation and central bank tightening was a concern well before the Russia situation got underway at the beginning of the year, through January. We've been thinking quite a bit about the 9/11 analog. So, it's interesting, 12 months before the planes hit the twin towers on that tragic day, the market was actually down 27%. Of course, you have dotcom bust going on, people's fears of a recession. In the immediate aftermath of 9/11, in the space of three or four days, the market fell 13% pretty vertiginously, as people worried that we'd never be able to fly again, and you know, terrorists potentially everywhere, and so forth. As that got cleared up, it was a very strong relief rally. So through to March 2002, the market then rallied about 21%.

But at that point, what was interesting is the market then remembered what it was worried about in the first place, which was these overly inflated valuations for tech stocks and a potential for recession, and so forth. Then the market rolled over again, and indeed, fell a further 34% through to October 2002. So, even if we do get a kind of sudden resolution of the Ukraine situation, and we get this relief rally, you know, you could have quite significant relief rally there. But then, we think the market remembers those inflationary concerns and the central banks will be forced to act. And the final thing is, I do just think the central banks really are wary of old anchoring of inflation expectations. So, we look at the University of Michigan inflation expectations, we take the average of the one year, and the five-to-10-year surveys, that's at about 4%, which is a full point and a half higher than its normal level prior to the pandemic. We think that threat is very real. Central banks are very aware of it and will need to respond to it.

Drew Nicol, AIMA  34:36

And we've mentioned UK and America a lot there, but the world is much larger. I mentioned at the top of the episode that UK inflation is around 4%. I think the US depending on who you ask is around 7% maybe which is, for someone under 40, red hot. But of course, there are many other markets in the world today and in prior years where that was a blip. So just taking a slightly wider view, for example, I read the other day that Turkey was 54%. If you can believe that. Are there any other markets do you pay particular attention to? I imagine those are related to commodities in some sense. But could you just give us an overview of what other areas are maybe canaries in the coal mine?

Henry Neville, Investment Analyst at Man Group  35:33

In terms of internationally, what I'm really interested to watch are country's where we haven't yet seen that inflationary pressure, feeding through into these sticker shock readings, because I think that when they start to move them, we really will start to know that this is this is becoming entrenched and broad based. And there's two areas really, which I'm watching quite closely. The first is Japan, it's been like the the figurehead for the secular stagnation and narrative over the past couple of decades. We're still yet to see much movement there in terms of price, right? So, on a core basis, we're still at minus 2%, pretty much year over year in Japan. So that has not moved yet. And I'm watching that closely. And the second thing is, you mentioned Turkey, and Brazil similarly, some areas of emerging markets experiencing really quite hot inflation. But there are other areas, particularly China and India, where they're certainly not in deflation. But the inflation readings they're getting, are not particularly notable relative to where they usually are through history, similarly with Japan, I'm watching China and India just to see whether that inflationary pressure we're seeing in the West moves over.

Drew Nicol, AIMA  37:01

That's interesting. So, it's actually a case of, we know it gets serious when it hits markets like Japan rather than early warning. Of course, where inflation goes rate hikes, at least in prior cycles quickly followed. If I think back as far as January, which in some sense seems like a lifetime ago, already, Goldman Sachs came out with the highest number that I saw, but many analysts were talking upwards of five hikes starting in March, which I think has now been confirmed that at least we'll start somewhat. But more recent events in Ukraine, and obviously, the global implications have dampened or changed that view somewhat. Where are we now? This is obviously very fluid. I won't call you to on this in in a few weeks’ time or even a few days’ time, but in terms of right now, where are we on that spectrum?

Henry Neville, Investment Analyst at Man Group  38:01

Yeah, so the short answer is in America, certainly, I don't think it's had a meaningful impact. So, to put the numbers on it, at the start of the year, derivatives markets are pricing in three Fed rate hikes, up to the 11th of February, which is where you'll remember Biden made that speech saying, essentially Russia is is going to invade that's basically where we date the start of the Russia-Ukraine tensions, that number have moved up to 6.4 hikes. That I think quite strongly makes the point that the inflationary story was well entrenched prior to Russia's invasion of Ukraine. Today, or when I checked, yesterday, it was at six, so, the Russia situation has priced out 0.4 of a hike in the US. So essentially, not much. Now, maybe in Europe, it does a bit more just because they're closer to the action. But ultimately, I think the world, and certainly financial markets follow America's lead rather than Europe, sad as it is to say.

Tom Kehoe, AIMA  39:12

And Henry, given all the exogenous factors that currently are in play at the moment, as well as all the noise by the various market commentators. What data points would you be using to model over the next 6 to 12 months in terms of managing inflation for your clients?

Henry Neville, Investment Analyst at Man Group  39:29

So there's a whole load of things I think you can do based on the historical data, I think there are three key ones. The first is cutting long-only risk parity type structures. So, derivatives of 60/40 and similar type strategies have done people incredibly well over recent decades, really, and that's largely because since about 2003, stock bond correlations, as we all know, have been negative through much of at least the Western world. And it really is worth saying, a lot of people know this, but for those who don't, that is an historically typical phenomenon. So, using the Bank of England data, you can go right back 250 years, and you can see that the large majority of the time stock bond correlations are significantly positive. So, this incredible diversification benefit managers have been riding in the past few decades where both equities and bonds have moved up together, but have done so at different times, which has been really good for Sharpe ratios. There is no reason that should continue from a historical perspective. And indeed, what we tend to see in historic inflationary regimes is as that regime becomes entrenched, the stock bond correlation rises. So, that's one key thing. Second thing is to add commodities as talking about as a historically been a very reliable performer in inflationary regimes.

Last year, when we looked at the world's top 20 asset holders, the big sovereign wealth funds, and so forth, we found that commodity allocation in aggregate was less than 1%. And it's understandable given that for quite some time, commodities have really underperformed. But we think probably, that needs to change. And the final thing is within bond portions of portfolios to cut duration, and to cut credit risk. And both of those things, both taking duration risk and taking credit risk have been really popular. Again over the prior few decades. And particularly in recent times, on the duration front, we saw lots of countries, Austria, I think famously releasing 100-year bonds and significant demand for that kind of issuance. We think that's a really bad place to be if we are and continue to be in an inflation regime. And on the credit side of things, we're aware of the pattern of a lot of credit benchmarks being degraded in quality terms. So, for instance, triple B has gone from about 25% of IG benchmarks in 1990, to about 50%. Today, and that's also reflected in a lot of portfolios, people taking more credit risk. In inflation regime, credit risk is not a good thing to be taking. And so, it's a consideration that one should reduce that.

Drew Nicol, AIMA  42:37

Well, Henry, this has been absolutely fascinating. Just hearing about all the ways in which someone like yourself and all the teams that Man Group, look to obviously apply lessons from the past and modeling using data available to navigate this period, and all the novel challenges that are coming when when old models don't work, when you overlay aspects such as new asset classes like crypto and how they are faring in their first rodeo of somewhat higher inflation. There seems to be a lot of lessons to learn here, and clearly this is something that will be ongoing for many weeks and months. It'll be so interesting to see how this plays out. You mentioned earlier that you've done a number of research pieces on inflation so far, just could you let our listeners know where they can find this.

Henry Neville, Investment Analyst at Man Group  43:34

My team has a microsite on the Man Group website. If you type www.man.com/DNA, then you'll find lots of relevant stuff.

Drew Nicol, AIMA  43:54

Excellent. Well, thank you so much for joining us on The Long-Short to this week. And I think all that's left is to wrap up there.

Henry Neville, Investment Analyst at Man Group  44:02

Thanks very much, guys. It's a pleasure.

Tom Kehoe, AIMA  44:04

Thank you, Henry.

Drew Nicol, AIMA  44:06

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