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Ageing populations, tempered appetites for austerity and a move to re-shore essential manufacturing are among the factors pointing to a sustained period of inflation. Can private markets help investors sustain returns?

These are difficult times for many investors, with rapidly rising inflation and stock markets volatile amid recessionary fears.

Many investors will be looking to reposition portfolios to invest in assets that are better placed to weather these economic crosswinds. This includes many private market investments, particularly high-quality loans and financing to small and medium enterprises (SMEs).

These robust and flexible investments offer a number of attractive characteristics for investors, enabling them to diversify portfolios and invest in sectors that are more resilient to rising inflation. They also enable investors to access assets whose performance tends to be uncorrelated with publicly listed equities and bonds. These are appealing features at any time, but are likely to be particularly prized in today’s turbulent and uncertain conditions.

Inflation: a longer-term problem?

When inflation started ticking up in 2021, many analysts and forecasters saw this as a temporary situation, driven largely by short-term supply issues on the back of the pandemic.

However shorter-term supply shocks have been exacerbated by the war in Ukraine, and the consequent sanctions imposed on Russia. Gas, oil and other commodity prices have soared as a result.

But these are not the only factors at play. Longer-term global changes point to economies around the world entering a more re-inflationary phase.

These factors include:

  • Debt – In contrast to the aftermath of the financial crisis (2007/08) there are now doubts about the appetite among policymakers for austerity. This may mean central banks allow economies to ‘run hot’ rather than taking concerted action to keep inflation at very low levels.

  • Demographics – It isn’t just Western economies that now have ageing populations. China is also seeing a demographic reversal, with its working-age population set to decline. As more of the global population switches from being net producers to net consumers, competition for productive workers will rise, fuelling wage inflation.

  • Globalisation/protectionism – The pandemic revealed the vulnerabilities of global supply chains. Governments are now recognising that a number of sectors, such as medical goods, vaccines and semiconductors, are essential to a country’s self-sufficiency – and, by extension, its national security. Business sectors are also re-thinking their efficiency-centric “just-in-time” model to incorporate “just-in-case” considerations and improve the resilience of their supply chains. This is likely to encourage re-shoring of manufacturing in certain sectors, protecting domestic capacity from international competition. This will likely make the process more expensive, again pushing up prices.

  • Green transition – In order to help limit global temperature increases there is likely to be a measurable rise in carbon prices to dis-incentivise fossil fuel energy products. In the longer-term, using more renewable energy sources should be disinflationary, given the low cost of marginal production. However, during the transitional phase, a rush to build the required infrastructure could be costly. In addition, the supply of renewable energy can be unpredictable, as storage technology is still in a developmental stage, and any intermittent reliance on traditional energy is complicated by the fact their supply capacity is already being wound down. This could lead to energy shortages, resulting in higher and unstable energy prices.

While few are predicting a return to high inflation levels of the 1970s, the consensus is that inflation will remain elevated in the context of the past decade. However, it may be that we are still at an early stage of the and it may also last longer than previously forecast.

“We are entering a period of uncertainty regarding inflation, where the risk is skewed to the upside, both from a near-term and longer-term perspective,” says Laurent Gueunier, head of real assets, SME lending and structured finance at BNP Paribas Asset Management “Inflation can be damaging to returns for investors, so it will become increasingly important for investors to manage this ongoing risk.”

Private assets: options for investors

Inflation can erode the purchasing power of a portfolio’s value, and be particularly detrimental to investors who rely on cash flows generated from traditional fixed income asset classes.

A move towards a more sustained path of inflation, even at only moderately higher levels, would represent a significant change from the disinflationary environment of the past two decades. During these more benign conditions, a typical investor with a mix of fixed income and equity investments barely had to worry about hedging inflation risks. Diversification came from the negative correlation of equities and fixed income assets.

But this has now changed. Both asset classes have underperformed in recent months. The move by central banks to raise rates has impacted returns on fixed income securities, while inflation has hit corporate valuations, particularly in sectors where profits remain more sensitive to pricing. There is also the ever-present threat that inflation could tip some economies into a recession, further impacting corporate profits and stock market volatility.

So it could be an opportune time to look at the benefits of private markets, and investments into SME loans and financing in particular. These can provide some protection against inflation, without compromising on yield or returns.

The SME lending market has expanded considerably in recent years, and there are now a range of investment options available. Funds, for example, offer the extra benefit of diversification, as they invest in loans granted to a range of SMEs and companies.

Gueunier points out that in many cases this financing is to companies who do not participate in listed bond markets – thereby helping investment clients further diversify their portfolios.

SME lending has evolved for financial rather than investment purposes, in order to provide alternative funding streams to the mainstream banks. Gueunier says this means loans tend to be robust and flexible, as the originating lenders want to maximise the chances of repayment throughout different market cycles. As a consequence, defaults have not been a significant problem.

Corporate defaults are of course a concern, given the less certain economic outlook. But by focusing on more resilient companies and sectors the risks can be more easily managed.

Gueunier explains: “Not all companies and not all SME loans are created equal. We are looking for financing to SMEs that are leaders in niche markets, rather than focusing on companies that are competing with leading players, or who have business models that rely on large volumes of sales and small margins.”

The fund invests in companies that have strong cash generation and a high asset value base – those that Gueunier refers to as having “pricing power”.

“We are looking for companies that are more resilient to rising costs and commodity prices, and have the ability to pass on these additional costs to clients because there is increasing demand for their products or services.”

He says this includes SMEs working across a number of key sectors, such as technology, healthcare, pharmaceuticals, business services and education.

If these companies are resilient to inflationary pressures, this means they will continue repaying their loans, delivering valuable income streams for investors.

Many private market loans are floating rate instruments, as they are essential banking instruments, where money is borrowed over the short term. But Gueunier says it is possible to move from a floating rate to fixed rate options in this SME loans market. This may be an option for investors to consider in the current environment. “This could add 2.5% extra return with no extra risk,” says Gueunier.

The challenge for investors over the next few years will be navigating inflation and protecting portfolios. By diversifying into private markets and learning more about the options, such as the SME lending market, then investors are likely to be better positioned to weather the uncertainty.

Disclaimer

Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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