How to inflation-proof your ISA

Inflation is now forecast to peak at over 7% in April, which naturally has many people worried about how that will affect their savings and investments, and as we head towards the end of the tax year, that concern will no doubt affect how savers allocate their ISA allowance. Current high rates of inflation mostly reflect price rises that have already happened, but even looking forward, the Bank of England expects inflation to run above 5% over the next twelve months. Meanwhile the average Cash ISA is currently paying just 0.34% in interest*, so many people will naturally find themselves turning to the stock market to help fend off inflation.

That certainly makes a lot of sense, because companies at least have the opportunity to pass price rises onto consumers. In fact, that’s largely what causes inflation, as measured by the Consumer Price Index. However, investors need to play a long game when using the stock market to beat inflation. Over the course of the year, there is absolutely no guarantee that an investment in the stock market will beat inflation. But over the longer term, investing in stocks can be one of the key defences savers have against rising prices.

The Bank of England reckons CPI inflation will be back to 2% by 2024. Maybe so, but the Bank’s forecasting capabilities haven’t exactly won any awards in recent times. However, inflation is extremely unpredictable, and we should acknowledge it might possibly tail off. Investors should therefore take a balanced approach with their finances, which means not betting the entire farm on a continued inflationary environment, while also picking some investments which can do well if inflation proves stickier than the Bank of England expects.

Companies with pricing power

Investors should also consider what kind of companies might prosper in an inflationary environment. Those with pricing power should be well placed to be able to pass their costs onto customers. Consider the fashion brand, Burberry, for instance. If you’re willing to shell out £2,000 for a Burberry trench coat, chances are you’re in a wealth bracket where inflation is a dim and distant problem, so a few extra pounds on the price tag aren’t likely to put you off a purchase. ESG investors won’t be interested, but tobacco stocks like BAT and Imperial Brands also carry pricing power because of the addictive nature of their key products. Companies with brand strength like Diageo and Apple have also shown the ability to push through price increases, but at 25 times and 27 times forward earnings respectively, these stocks trade at very lofty valuations. So while these businesses may be able to protect profit margins against inflation, the stock price may be vulnerable to inflationary pressures (see section on stocks on high valuations below).

Financials

Financials might be another area that could benefit from inflation, albeit indirectly. Banks, for instance, make a turn out of taking deposits and lending them out, and the difference between the rates at which they borrow and lend should increase with rising interest rates. Increased living costs do have the potential to mean more bad loans for banks, but rising wages, combined with savings stashed away by consumers during lockdowns, should mean the vast majority of people will continue to be able to service their bank debt. Particularly seeing as most of the mortgages sold recently have been fixed rate, which means that interest rate rises will take a while to filter through to many borrowers. Lloyds for instance, offers investors a slow and steady UK focussed bank, which should throw off a decent dividend, again a bit of help against inflation. HSBC, by contrast, is a global bank, and in fact most of its profits now come from the faster growing far eastern region, though that of course carries its own risks.

Commodity stocks and ETCs (Exchange Traded Commodities - an ETF for commodities)

Investors might also think about investing in the key sources of inflation, in particular energy and raw materials. It would be hard to see inflation continuing to be elevated without these prices also increasing, which would be positive for producers like Shell, or Rio Tinto, or indeed a more diversified metal and mining fund like BlackRock World Mining. Some inflationary expectations are already baked into share prices in these sectors though, which explains their positive share price performance in the last six months. These stocks are also extremely volatile, so a considerable risk appetite is required before jumping on board. Investors might be tempted to invest directly in commodities like oil and gas through ETCs (Exchanged Traded Commodities), but these funds normally use derivatives to gain exposure, and often come with complex costs, which mean that there can be a disconnect between the price movement of the commodity and the return from the ETC. As such, they should only be considered by sophisticated investors who have a very good handle on how they work.

Cyclical funds

Index investors looking for a regional market to gain exposure to mining and financials might look at a FTSE 100 tracker, like the iShares Core FTSE 100 ETF. Energy, resource and financial stocks make up around a third of the index. While this clearly isn’t a pure play, if you’re simply looking to tilt your portfolio towards more cyclical sectors in a low cost, simple way, it ticks a lot of boxes. For an active fund, Jupiter UK Special Situations also has around a third of its portfolio invested in financials, energy and resource stocks, and the manager’s quality value style looks well-placed to come back into favour in an inflationary environment.

Gold

Gold often comes to mind whenever inflation raises its head. Unlike barrels of oil and cubic metres of gas, gold bars are (relatively) easy to store, which means there are some ETCs available which hold physical gold, such as iShares Physical Gold ETC, so you don’t have to worry about the complexities of derivative pricing. Gold can be volatile however, and there is little to link its performance to inflation, other than conventional wisdom. Indeed, the gold price has been trading at around $1,800 an ounce for most of the last year, and the recent inflationary surge hasn’t pushed the price up in the way that gold bugs might have expected. Partly that may come down to the fact higher interest rates aren’t good for gold, because it doesn’t pay an income, and cash and bonds therefore become relatively more attractive when interest rates are on the up. Gold is an asset which can be expected to perform differently to others though, and is a bit of an insurance policy against disasters elsewhere in markets, so it can work as some diversification in a portfolio. Typically for private investors exposure should be limited to 5% to 10% or so.

Cash and bonds

Cash is necessary for short term spending needs, but clearly it’s very exposed to the ravages of inflation, so you should only look to hold an emergency buffer of three to six months expenditure. Government bonds, and in particular long dated government bonds, are also extremely vulnerable to rising interest rates, and so investors should review any exposure they have to this asset class. Index-linked gilts in theory offer some protection from an inflationary storm, but are currently priced so high they act more like a fig leaf than a weather-proof jacket. The 10 year RPI linked gilt is currently yielding minus 2.5%, which means that if you hold it to maturity, you will receive back 2.5% less than inflation each year for ten years. So not too appealing either.

Stocks on high valuations

We may also see some highly valued areas of the stock market struggle too. There are some stocks, particularly in the tech sector, where their elevated price is built on expectations of future earnings, rather than profits they are making in the here and now. Tesla is a good example. However inflation, and higher interest rates, make distant cashflows in years to come less valuable, and in fact this calendar year we have already seen some frothy areas of the market sell off as a result of this dynamic. Sustained inflation, or fast interest hikes, could see this play out further.

*Source: Bank of England. Average interest paid by all Cash ISAs over the calendar year 2021.

These articles are for information purposes only and are not a personal recommendation or advice. How you're taxed will depend on your circumstances, and tax rules can change. ISA rules apply. Remember that the value of investments can change, and you could lose money as well as make it. Past performance is not a guide to future performance.