How to shelter investments from an inflation storm

The latest US inflation figures for April are worrying, though we need to bear in mind that April 2020 was a weird month, where the first wave of the pandemic was in full swing, and the price of some US oil contracts fell below zero. Nonetheless, markets are rattled by the prospect of rising inflation, and we could be witnessing the start of a new chapter for the global economy, characterised by prices rising sharply, rather than plodding along in the modest and benevolent manner of the last decade. Inflation is the ultimate stealth tax, and savers and investors should now be taking steps to ensure their portfolio is prepared for the possibility of rising prices.

Central banks have thrown the kitchen sink at the pandemic, though they acted similarly in 2009, without prompting rampant inflation. What’s different this time is that monetary firepower is backed up by huge amounts of fiscal stimulus, healthy consumer finances after a year of abstinence, and a banking sector that isn’t looking to shrink its balance sheet, as it was in 2009. Consequently, in recent weeks, UK inflation expectations have climbed to their highest level since the financial crisis. Indeed, except for a relatively brief period in 2008 when sterling was plummeting, inflation expectations are at their highest level since the turn of the millennium. (See charts below).

Policy makers are sticking to the tune that inflation is temporary, as we begin to lap big pandemic falls in commodity prices last spring. So in the near term, rising inflation doesn’t spell interest rate rises, in and of itself. However, if rising prices are accompanied by falling unemployment as the pandemic recedes, that will make markets even twitchier about the loose monetary policy that has been propping markets up for 12 years. US unemployment still stands at 6.1%, much better than last year, but still way above the end of 2019. Should that number drop sharply, markets will be increasingly focused on the Fed’s trigger finger. Here in the UK, the Bank of England now sees unemployment peaking this year at 5.5%, down from its previous forecast of 7.75%, a very significant improvement in the economic outlook, which could hasten tighter monetary policy on these shores. Central banks certainly have plenty of scope to raise rates from such low levels to control inflation, but that dose of monetary medicine might come with some nasty side-effects for markets.

All this means investors need to take stock of their portfolios, to ensure they’re prepared for any significant rise in inflation. Investors should consider moderating exposure to long duration assets such as government bonds, and growth stocks trading on high multiples. These assets can still provide useful diversification should inflationary pressure fail to materialise, so needn’t be jettisoned entirely. The release from social restrictions is a unique phenomenon, and forecasts of macroeconomic factors are subject to a wide degree of error, so inflation is not a done deal. However, these assets have performed extremely well over the last decade, and they may now make up an excessive part of investor portfolios. They might, therefore, be in a need of a trim to achieve a balanced portfolio that factors in today’s inflationary risks.

How to invest for inflation

Fixed interest securities won’t take kindly to rising inflation, particularly long dated government bonds. Conservative investors who want to retain bond exposure might consider shifting towards Strategic Bond funds, such as Fidelity Strategic Bond, which have greater flexibility to invest across the fixed interest spectrum and avoid the worst of any bond market turmoil. Funds like this can offer diversification from an equity portfolio, but as with all fixed interest investments right now, investors may be left feeling slightly less than lukewarm by the income yield on offer. Alternatively, to achieve diversification, conservative investors might consider a multi-asset fund, which contains a combination of equities, bonds, cash, and sometimes property, gold and currency exposure, with a professional fund manager deciding when to move between asset classes.

Equities - in the short term an inflationary shock would likely hit stock prices across the market, but in the long run, shares offer a better inflationary hedge than cash or bonds. Shares trading on high price earnings multiples are likely to find themselves at the forefront of any inflationary stock market sell off, and we have already seen some evidence of this in the inflationary jitters exhibited by the market in the last few months. In particular, higher inflation would take some of the shine off the big US tech titans, whose lofty prices are largely built on expectations of future earnings. That perhaps explains why retail investors withdrew £1 billion from US funds in March, a big shift in sentiment towards a hitherto popular sector.

Companies trading on lower valuations could offer some shelter from an inflationary storm, so a value orientated fund like Jupiter UK Special Situations might help broaden portfolio exposure away from more growth facing areas. Commodities producers might also offer sanctuary in an inflationary environment, as the price of raw materials should rise too, so a diversified pool of mining companies as offered by Blackrock World Mining investment trust might fit the bill. However investors should expect volatility given the extremely cyclical nature of the mining industry, and should only put a small amount of their portfolio in a trust with such a narrow focus.

Companies with pricing power should be able to pass inflation through to customers, for instance strong consumer brands like those of Unilever or Diageo, or companies which offer essential services that are difficult, costly or risky to replace, like Sage or Rightmove. However, the reliable recurring revenues of these companies has already elevated their valuations, and hence inflation could pare those back, taking the shine off any rise in earnings. Some of these steady-eddy growth stocks have also become homes for traditional bond buyers, exiled from their natural habitat by exceptionally low yields. If inflation causes bond yields to rise, these investors may find themselves tempted back to more familiar surroundings. These companies with strong consumer bases and wide economic moats are likely to still be good investments for the long term but given their strong performance for such a long time, investors should consider whether their portfolio already has plenty of exposure.

Property should in theory also offer an inflationary hedge, as rising consumer incomes should spell higher house prices. However, strong inflation would likely mean interest rate rises too, and that could mean problems for mortgage affordability, even though wages should be increasing in an inflationary environment. Taking out a fixed term mortgage offers some reassurance over the affordability of interest payments in the short term, but that still potentially leaves borrowers exposed to higher interest costs when their fixed term deal expires. Higher interest rates may therefore offset rising wages and put a lid on house price growth. Buy to let investors also need to factor in recent tax rises, namely higher rates of stamp duty and the limitation of mortgage interest rate relief to 20%. Unlike shares, investors can’t stick a residential property in an ISA to shelter it from tax. Maintenance costs and void periods also need to be included in any consideration of the benefit of buy to let.

Cash, in most cases, is already going backwards in real terms, and higher inflation will exacerbate this issue, unless interest rates rise above the rate of inflation. Central banks have set out their stall pretty clearly on this front - they’re willing to tolerate higher inflation for a while before pulling the emergency cord of interest rate hikes. So if inflation does start to take off, cash interest rates won’t respond immediately, leaving money in the bank losing its buying power more rapidly.

Pension investors who are about to retire might think twice about buying a level annuity when they do, which simply pays the same amount year after year for the rest of your life, and so can be seriously ravaged by the long run effects of inflation. It’s possible to buy an inflation linked annuity, but rates start at a much lower level - around 3% per annum compared to 5% per annum. This does protect you from price increases, though it’s a costly insurance policy. You don’t have to do one or the other, you can mix and match to get a higher income now with some inflation protection built in too. Alternatively you can invest some or all of your pension in income-producing shares, and in the long term, rising dividends should help to combat inflation. As you approach retirement you should also be wary of being automatically switched into ‘lifestyle’ funds, particularly if you have an old company pension, or a Stakeholder plan. These lifestyle funds invest in long dated government bonds, in order to hedge annuity rates, but if inflation rears its head, these funds could fall significantly in value.

UK inflation expectations

The chart below shows the UK 10 year breakeven inflation rate, a widely used indicator of market expectations for UK inflation. It’s the inflation rate at which the returns from a conventional gilt and an index linked gilt are equal. The chart shows how UK inflation expectations have risen sharply this year, as the success of the vaccine programme, combined with monetary and fiscal stimulus, have improved the economic outlook, and at the same time stoked concerns over rising consumer prices.

Data from the US shows a similar picture:

These articles are for information purposes only and are not a personal recommendation or advice.