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How private markets can help navigate rising inflation expectations

How private markets can help navigate rising inflation expectations

Summary

Many commentators expect the recent rise in inflation to be transitory, but a longer-term reflationary trend – or an increase in inflation expectations – cannot be ruled out. Against this backdrop, private-markets assets have a range of characteristics that could help investors hedge against – and even benefit from – any sustained return to inflation.

Key takeaways

  • Assets under the private-markets umbrella have various built-in hedges if the recent rise in inflation becomes a longer-term trend
  • Inflation within the forecast 2%-3% range should be easily absorbed by many private-markets strategies as these levels are already built into pricing assumptions, and could even offer opportunities
  • The structures in which private-markets strategies invest are often less impacted by inflation, and can even flourish in an inflationary environment
  • A sector-specific focus on issuers and organisations with a track record of dealing with previous periods of inflation should serve investors well

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The return of inflation has presented investors with a challenge. The search for yield must now be coupled with a need to protect against inflationary trends. Several strategies under the private-markets umbrella look well-positioned to provide that hedge – and could even flourish if higher inflation persists. Moreover, the geographical spread of private-markets strategies can help investors diversify across economies at different phases in the inflationary cycle and varying responses by central banks. While some private-markets strategies are fixed rate with long duration, they may not necessarily underperform in an inflationary environment if actual inflation does not exceed market expectations for inflation.

Private markets are well-equipped for a range of inflationary environments

After the financial crisis of 2007-2008, the economy settled into a low-inflation, low-growth environment. But recently, monetary and fiscal stimulus as part of governments’ response to the Covid-19 pandemic has coincided with economies surging back to life. The release of pent-up savings has met with supply-side issues and a labour shortage, putting inflation firmly back onto the agenda. But will this environment last? There are two general views:

  • The market consensus is that this inflation surge is transitory, and there is a fairly low risk of lasting inflation. In this view, the underlying causes of the latest inflation rebound should subside as the world’s economies “reboot”, people return to work and supply chain issues are resolved.
  • The contrarian view is that the risk of medium-term inflation is underestimated by the markets. Inflation may surprise on the high side for longer, even if the actual year-over-year inflation numbers peak this year. Certain structural forces could keep inflation higher – including significant shifts in the monetary policy of major central banks, a changing labour force and ongoing deglobalisation.

Regardless of which view prevails, strategies across the private-markets universe may be well-equipped to deal with any fluctuations, and a general reflationary trend could provide opportunities for these asset classes. This paper takes a closer look at how various private markets can benefit from a range of inflationary environments.

An inflationary environment is generally good for credit and equity in the early stages, but if rate increases persist, default rates could rise as well. Infrastructure-like industries – which can frequently be accessed in the private markets – can often feature lower default risk. Moreover, one of the clear strengths of private debt is that usually it has preferential treatment in a default, and higher recovery rates, than public debt. It is worth noting, however, that we do not expect a big jump in defaults as many higher-risk businesses have used the historically low interest rates to “term out” their debt.

A closer look at how private- markets strategies can turn inflation into opportunity

The private-markets universe is vast, and each component has its own unique qualities that respond differently to inflation. Here’s a closer look at several key areas:

Beyond inflation: look to private markets for yield and return potential

The long-term, buy-and-hold nature of many private-markets investments, and their ability to absorb or pass on increases in costs mean that, to an extent, these strategies can provide investors protection against inflation – both from a mark-to-market and fundamental perspective.

But private-markets strategies can offer more than that. They may hold opportunities for investors to find yield and access returns, whether through identifying the sectors and companies that are positioned to flourish during an inflationary environment, or through a structure that delivers a close correlation with inflation. For many, a return to inflation will not be feared. In the context of these strategies, it could even be welcomed.

Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Additionally, this information is not intended to provide, and should not be relied on for, accounting, legal, tax or other advice. You should consult your advisors regarding such matters. Private markets involve a high degree of risk and prospective investors are advised that such investments are suitable only for persons of adequate financial means who have no need for liquidity with respect to their investment and who can bear the economic risk, including the possible complete loss, of their investment. Private markets will not be subject to the same regulatory requirements as registered investment vehicles. The investments may be leveraged and may engage in speculative investment practices that may increase the risk of investment loss. Such investments are not expected to track a particular benchmark. Fees and expenses may offset its trading profits. The portfolio managers are expected to have broad trading authority. The investments generally involve complex tax structures and there may be delays in distributing important tax information. Certain investments may invest in non-publicly traded securities which may be subject to illiquidity risk. Performance could be volatile; an investor could lose all or a substantial amount of its investment. Past performance is not indicative of future performance. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security.

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Don't downsize your dreams

Inflation cheat sheet: Key facts, figures and definitions

Inflation cheat sheet: Key facts, figures and definitions

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