OPINION OF THE WEEK: Wealth Managers Must Set Expections In Inflation Age

Tom Burroughes

23 June 2023

Sifting through a variety of stories about investments, policy decisions and the views of family offices (see here) in recent weeks, it’s hard to ignore the “i-word” – inflation.

High and persistent inflation in the UK prompted the Bank of England to hike rates by half a percentage point to 5 per cent this week. While in recent “pause” mode, the US Federal Reserve may hike again. And so it goes for the European Central Bank, Swiss National Bank and others.

From wealth managers’ point of view, beyond all the arguments about who is to blame for this state of affairs (I incline to the idea that we are paying the price for more than a decade of quantitative easing), they have the task of trying to reframe clients’ expectations. A person with $100 saved now would, if holding that money for five years with an average inflation rate of 3 per cent, end up with $86.26. Over a decade, the money melts to $74.41. (As an aside, the ravages of inflation mean that the term "high net worth", which used to represent at least $1 million of investable assets, needs to be seriously updated.)

Assuming that central banks’ actions succeed in bearing down on inflation, it is bound to cause pain as those “zombie” firms able to stagger on in a low-rate world go out of business, or restructure. (That’s a good thing, as it releases capital for more productive uses.) Some people, where their outstanding loans are many multiples of their post-tax income, will be in trouble, both on the commercial as well as residential side. Certain economic sectors could suffer as people cut non-essentials. Smart asset allocators need to take this into account in terms of the business sectors they hold, and from conversations I am having, they already are doing so. Businesses with a strong defendable “moat” – the sort of firms that make money come rain or shine – will be in portfolios. More speculative businesses with less visibility on earnings will have a harder time making it into clients’ holdings.

With the risk-free rate – which equates to yields for US T-Bills and other major government bonds in developed countries – moving above 4.5 per cent and thereabouts, it is also going to mean that a lot of investors’ enthusiasm for splashing around in the shores of riskier investments will fall. And that includes forms (not all) of private equity, venture capital and types of real estate. Some of that razzmatazz has gone.

For years on end I have been told that private market investing is a hot area, that family offices and everyone else wants a piece of the pie, and the illiquidity premium is worth the trouble. Well, up to a point. A few days ago, Bloomberg had these harsh words: “Many private equity firms opted against hedging arrangements that could have shielded companies saddled with $3 trillion in floating-rate debt from rising interest costs, that in some cases, doubled or more.”

Even allowing for a certain amount of hyperbole (we journalists have our weaknesses for it), that’s pretty damning. The demise a few weeks ago of Silicon Valley Bank had several causes, but the tightening monetary conditions to fight inflation was surely one of the main reasons. And while no business and economic cycle is ever exactly the same, it does, to quote Mark Twain, rhyme. So yes, private market investing, when done over the long term, is an important part of HNW portfolios. But advisors need to tell clients that the game has become more selective, and to be even more aware of the risks.

Wealth managers are going to have to guide clients over what their liabilities and spending habits are, because without being able to keep pace with inflation, some of that will have to be cut. This week, Swiss private bank Julius Baer issued its annual report showing how much it costs to enjoy the high life around the world. Singapore is the most expensive. But even for HNW and ultra-HNW individuals, the erosion of wealth caused by inflation means that complacency has to go.

We are likely to hear a bit more about gold, given its historical status as a hedge against inflation – although it is not a linear relationship. (See this story about UBS.) Interestingly, cryptocurrencies have been so volatile in recent years that it’s hard to see any hedging benefit. I think these cryptos need to be around for far longer, and with a track record of stability, before they play any part in the “safe-haven” department.

Rising rates mean that cash-like entities such as certificates of deposit are worth something again and asset allocators might start pronouncing more on the advantages of other cash-like products. And although banks have been through rough times lately, let’s not forget that rising rates – within certain bounds – are good news for banks’ net interest margins. Swiss banks laboured for more than half a decade under negative official rates. No longer. Maybe some financial sector firms, particularly if their balance sheets are robust and they have managed their bad loan exposures wisely, will fit into some fund managers’ asset allocations.

The current episode is also a reminder that all those comments down the years about behavioural finance, and how this can inform decisions, should not be forgotten by wealth managers when they sit down with clients. Advisors must be attuned to how, for some, often older clients, the environment is a new one. I am old enough to have experienced double-digit inflation and events such as the recession of the early 90s (I have the grey hairs to prove it). Quite a lot of adults haven’t. So some of us older people in the industry can win new respect by drawing on that experience.

And what all this amounts to is that experience, a sense of perspective and composure, are qualities that are as in demand now as they ever were. Wealth managers’ “added value proposition” is often most evident when times are tough.