Investing in a rising inflation environment
What is happening?
Inflation has been a challenging factor for investors to grapple with in 2021 and this is likely to be a central concern as we now move into 2022. More recently, we have seen high CPI data coming out of the US and UK. So, what are the causes of this surge in inflation?
The global vaccination program has enabled economies to reopen and has driven a recovery in sectors that have been most severely impacted by the pandemic. At the same time, monetary policy in developed markets remained accommodative, fuelling the strength and pace of recovery, and leading to supply shocks across global industries. A steep rise in energy and raw material prices has raised concerns about inflation and the prospect of central bank action in the form of interest rate rises. Labour shortages, supply issues and shipping and distribution bottlenecks are all contributing to inflationary pressures. There are also structural changes that will potentially drive longer-term inflation such as climate change (i.e. energy transition).
All of this will impact investor sentiment and asset prices directly. Equities have already come under pressure as markets adjust expectations to the prospect of higher rates. Bonds markets have moved in reaction to shifting expectations with yields moving higher. There is the risk of further, more significant moves higher in yields, as we see central banks act.
Is the inflation transitory?
It is still difficult to determine how persistent this inflation will be and there are strong views on either side of the debate. Some believe we will remain in a low-inflation environment, but the new normal may be above the historic lows we had grown used to before the pandemic.
There are concerning signs as inflation has remained elevated for several months now. One of the key areas in consideration is the labour market and the question of whether wage pressures will drive inflation higher? Central banks will be monitoring this closely. Ultimately, they will aim to balance the risk of higher, persistent inflation with the task of supporting the fragile economic recovery. Indeed, concerns about high debt levels in the economy may temper the strength and speed with which central banks move to combat price pressures. In not acting swiftly, they open the possibility of a policy error, allowing inflation to become unmanageable. If market concern of a policy error grows louder, we could see significant rises in government bond yields.
The steep surge in energy prices may be the precursor for recession. The knock-on effect of higher energy/utilities costs is likely to hit consumers hard. For corporates, the higher input costs will lead to declines in corporate profitability. As global central banks begin the process of tightening policy, with QE tapering (where asset purchases are reduced), we might expect weaker economic growth.
There are significant factors that could derail the current economic drivers. For example, the emergence of a high-risk variant of Covid 19 as we have seen in recent weeks could change the landscape for inflation as the potential for partial or full lockdowns re-emerge, leading to slower economic activity and demand.
The peak in inflation and the timing and extent of any slowdown is more difficult to predict and therefore we believe positioning portfolios for a higher degree of economic and market uncertainty (and potentially higher volatility) is sensible.
What can investors do to combat inflation?
Inflation erodes the purchasing power of cash. In other words, when the rate of inflation is higher than your current fixed rate of interest on cash savings, it reduces the value of that money over time. Whilst interest rates remain at historic lows, this makes cash an unattractive asset class for investors.
From an asset allocation perspective, investors should review the level of exposure to fixed income within the scope of their own individual investment risk tolerances. Rising real yields and inflationary pressures are a real concern for investors. Unconstrained or strategic fixed income funds have greater flexibility to position a portfolio in a way that lessens the impact of rate rises. Where investors do hold direct conventional fixed income, they might opt for a short-duration portfolio of bonds, which are less sensitive to interest rate rises.
The mix of a bond portfolio might be altered to include high-yield corporate bonds which are typically shorter duration and have a credit spread to compensate for the risk of default.
Some investors hold inflation-linked bonds (gilts or US TIPS) to insulate the portfolio from the effects of inflation. Short-duration TIPS have tended to be less sensitive than long-duration bonds during periods of rising rates. Floating rate bonds, which move in line with interest rates, may also be a useful way to reduce interest rate sensitivity of a portfolio.
Within an equity portfolio, it can be useful to hold exposure to beneficiaries of inflation (e.g., financials or commodities/energy sectors). It is also worth considering a tilt in the portfolio towards companies with strong market share, pricing power and the ability to pass on price increases to end consumers. They should be able to weather a period of inflation better than more economically sensitive businesses.
There are also a number of “alternative” assets that may be considered in a risk balanced portfolio. Infrastructure assets can provide revenues linked to the rate of inflation and therefore have a part to play a diversified portfolio. However, it should be noted that listed infrastructure is highly correlated to equity markets and therefore there are limitations to its diversification benefit in the shorter term.
Metals and minerals used as raw materials in industrial production will typically offer a positive correlation between commodity prices and inflation. Gold has been historically considered as a hedge against inflation.
How we think about inflation at Five Wealth
At Five Wealth we are not trying to predict the path of inflation, but we do seek to mitigate risk where we can through our asset allocation and fund selection process. We understand that our clients invest to their own time horizon which does not neatly tie in with the market/economic cycle. We believe that investors benefit from investing in a range of asset classes which having differing performance characteristics. We believe that diversifying across global markets is vital. Different regions/countries will be at various stages of the economic cycle providing risks and opportunities.
Whilst we believe there can be a place for passive investments in a client portfolio, we firmly believe that active management can add value and help to mitigate the negative effects of a shifting economic backdrop. An actively managed fund enables the fund manager to make stock and security selections based not only on the fundamental characteristics of the asset but also taking account of how broader economic conditions might impact it. For example, they might select an equity investment in a company with the ability to pass on rising prices to their end consumer. In the fixed income space, this might mean selecting a security with less interest rate sensitivity. The multi asset fund managers that we recommend to clients also can invest in alternative asset classes which have lower correlation to equities or bonds.
As we move forward, we remain aware of the risks posed by inflation and are in active dialogue with fund managers to determine how they might position portfolios for the shifting macro environment. As inflation rises, consumers and investors will find their disposable income squeezed. In such an environment, we look to help our clients achieve positive “total returns” in real terms which will ultimately help them combat this inflationary pressure.
Please remember that your capital is at risk. The value of your investment (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.