Inflation is picking up. The Bank of England said last week that it expects weakness in the pound to propel inflation higher to 2.7% next year, which is well above its target rate of 2%. The market also believes that policies proposed by President Donald Trump are likely to be inflationary. He plans to boost spending on neglected US infrastructure such as bridges and roads, which is positive for the construction industry as well as the demand for metals and other materials on a global basis, potentially pushing prices up.
How might investors adapt to this potentially changing environment? Some areas are more vulnerable if inflation increases markedly, notably bonds, whereas others cope much better. Here’s a look at some of the key assets that might offer some resilience if inflation increases.
A common assumption is that an inflationary environment is good for equities. The reality is more nuanced. Shares tend to retain their “real” (or inflation-adjusted) value over long periods but the journey can be an uncomfortable one as sentiment changes regarding the level of inflation and the impact on company profits.
Earnings are increasingly unreliable in a period of rapidly rising inflation: The cost of goods sold is based on the price paid for raw materials last year, not what they cost today; and the cost of assets are depreciated from their purchase price years before, not what it costs to maintain them now.
For an inflationary environment companies with low capital intensity and higher margins should fare relatively better, particularly if they have “pricing power”, traits that allow them to raise prices for products and services without significantly reducing demand.
Firms in areas such as consumer products, software and pharmaceuticals, rather than industrials are relatively well placed. Liontrust Special Situations is one fund focuses on many companies with low capital intensity and pricing power. Additionally, Artemis Global Income, Perpetual Growth and Income Trust and Standard Life Equity Income Trust are examples of investments that aim for a sustainable and rising income stream that might cope pretty well.
Investors should be sceptical of assets with high and stable income but long cash flow durations if inflation ramps up. A high income today could dwindle to a low one (in real terms) in 10 years’ time in a high inflation environment. Assets that produce income streams that do not rise are vulnerable, most obviously conventional bonds. Long dated gilts, traditionally a low-risk asset, could be particularly toxic.
Although investors’ expectations of inflation have increased in the past six months (and prices have fallen and yields risen as a result), this is only a taster as to what could happen to the bond market if inflation really took hold. For this element of a portfolio investors could instead turn to inflation linked securities.
Index-linked gilts are one option as they would likely fare better than conventional bonds. They are expensive currently, and in some conditions when interest rates rise, they could lose investors money. They are not a simple guarantee of a real return but would help guard against unexpectedly high inflation. M&G UK Inflation Linked Corporate Bond Fund is one convenient option for fund investors. In contrast to most bond funds, it invests in a range of bonds, including index-linked gilts, which should perform well when inflation is high or rising.
Property and infrastructure
Property assets could help to a degree, but if rents don’t rise (perhaps due to high competition or falling demand) then they could be vulnerable. Infrastructure assets that have a certain amount of contractual inflation protection built in are perhaps more desirable. They can potentially provide investors with an attractive, income-orientated return and welcome diversification from equity markets.
Investment funds specialising in this area back wide variety of projects to help spread the risk and avoid over-reliance on a single area. Given that these investments are ‘illiquid’ – i.e. cannot be bought and sold readily – having a fixed pool of capital for a fund manager to administer is a sensible route, hence the investment options tend to be investment trusts rather than open-ended funds such as unit trusts or OEICs.
Large, diversified investment trusts such as International Public Partnerships, HICL and 3i Infrastructure invest across a wide range of assets in the UK and overseas. Shares offer yields of around 4% presently (variable not guaranteed) but the downside is they tend to trade at a premium to their net asset values given the combination of high level of income they produce and the prospect for this to have some inflation protection built in.
Finally, gold can be used as some portfolio “insurance” against really high inflation. It offers some diversification and tends to maintain its spending power over long periods of time. However, it yields nothing and tends to be volatile, which is exactly the opposite of what many investors are looking for! There are a wide range of exchange traded investments offering exposure but we would suggest only dedicating a very small part of a portfolio to this asset class.
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