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How could higher inflation affect your investments?

Increasing inflation can have a significant impact on your investment returns as well as your household finances. Rob Morgan explains which investments are most at risk and which could be more resilient.

| 10 min read

Ronald Reagan once described inflation as being “as violent as a mugger, as frightening as an armed robber and as deadly as a hit-man” – and it’s true that price rises across the economy can have a nasty effect on your finances over time.

At a fairly modest rate of 2.5%, a basket of goods and services that cost £100 ten years ago would cost £128 today – it means that if you aren’t earning returns on your savings and investments over and above the rate of inflation your wealth is going backwards.

Investors have had little need to worry about high inflation over the past decade – but that could be changing. If so, many that have been used to low inflation it could be a significant shock to household finances. Unless interest rates rise significantly, a jump in inflation is likely to put a significant dent in the spending power of cash in the bank or building society, and there are consequences for investment portfolios too.

Financial ‘repression’

To stave off economic crisis during the pandemic the world’s Central Banks, led by the US Federal Reserve and the European Central Bank, have created vast amounts of money. This has propped up many businesses and individuals, but it has also given some ‘extra’ money to spend. Combined with the effect of ‘revenge’ spending – as people make up for opportunities lost in lockdown – it means there could be lots of money chasing goods and services.

What’s more, some products could be in shorter supply as companies have pared back inventories during the uncertainty of the pandemic. In the leisure and tourism sectors there are reportedly staff shortages as those previously employed have ended up looking elsewhere during lockdown and decided not to return. This is all a recipe for inflation, at least in the short term.

Ordinarily, central banks would put up interest rates to reign inflation in. Upping the cost of borrowing takes the heat out of economic expansion and rising prices. However, authorities have made it clear they are willing to tolerate some short-term inflation to prioritise economic recovery and jobs. If inflation really takes off, then the authorities will have to act, but the US Federal Reserve and others have said they won’t be worried by figures more than 2% a year if they think it temporary.

Investment implications

The market is currently torn between thinking the Fed won’t need to raise rates and thinking that it will. Keeping inflation under control is one thing but containing market expectations is another. Ultimately, if the market thinks inflation is a problem it may force the central bank’s hand by pushing up longer-term interest rates in bond markets.

Yet that may be little consolation for cash savers as any interest rates on cash could still lag inflation by some distance – a quite different experience to previous decades where competitive cash rates did a reasonable job of keeping up.

As well as being a notorious bogeyman for savers, inflation tends to be bad news for various types of investments. The most obvious casualty is bonds, especially if they are priced for a very long period of low rates and accommodative policy. Most bonds such as UK gilts and US treasuries pay a fixed amount, so as inflation and interest rates rise their capital value must fall to provide the ‘right’ amount of return to investors - often this is known as the 'risk-free' rate as these stable bonds are considered exceptionally safe because developed world governments are most unlikley to default.

Already we have seen a significant amount of volatility in bond markets as investors grapple with the risk of inflation. The action has mostly been in longer dated bonds which are the most sensitive to movements in interest rates, and its quite likely we will see more volatility going forward as economic data ebbs and flows and investors decide whether the increase in inflation is temporary or not.

Bond movements tend to have an immediate impact on equity markets. That’s because company earnings, are priced partly with reference to bond yields as a yardstick. The higher inflation, interest rates and bond yields are the less future profits are worth in today’s terms. This has significant consequences for more expensively valued areas of the market where reliable or rapid future growth is priced in. Having benefitted most from falling interest rate expectations over the past few years, technology and growth stocks are among the most challenged if the tide turns decisively.

How to combat inflation in your portfolio

The good news is a well-diversified investment portfolio can help preserve and grow a nest egg amidst the ravages of inflation. Here is a look at some components you could consider if you have this risk in mind.

Shares

Company earnings and profits often, overall, increase at a faster rate than prices of goods. However, high levels of inflation tend to be something of a double- edged sword. If a company cannot pass increased costs onto customers, then it can result in a fall in sales and profits. Firms with ‘pricing power’, whose products and services are in strong demand, can put up their prices to reflect higher costs, and should, in theory, be better placed to cope. For some businesses this could help offset the impact of rising bond yields described above.

It’s also worth considering areas that will benefit most from higher inflation. If inflation it does rise it may well be because the economy is running hot and companies sensitive to consumer spending – including many previously embattled areas such as travel and leisure – might be well placed to benefit. Banks are also a potential beneficiary of higher interest rates as they can earn a greater amount on their deposit and lending activities.

Inflation caused by increasing commodity prices can also be directly countered in a portfolio via some exposure to the mining and energy sectors. Funds with a decent allocation, or perhaps even specialist ones dedicated to these areas, can help diversify a portfolio.

In terms of geographical opportunities, the UK stock market has plenty of exposure to commodities and banks, while Japan has lots of financial and industrial stocks that could benefit from a buoyant global economy and a bit of inflation.

Inflation-linked bonds

Unlike conventional bonds, index or inflation linked bonds provide an income that rises. They tend to offer some protection from an increase in inflation expectations, though they can become expensive when lots of investors are looking to protect themselves from this risk and drive up prices - so they don't always work as a hedge.

Some multi asset funds and investment trusts hold a significant amount in inflation-linked government bonds, often UK gilts and US treasuries, for their diversification benefits, for instance Personal Assets run by Troy’s Sebastian Lyon and Ruffer. Alternatively, there are specialist funds that target this niche asset class such as exchange traded fund Xtrackers II Global Inflation-Linked Bond UCITS ETF.

Property and infrastructure

Property funds such as unit trusts or investment trusts primarily invest in commercial property such as shopping centres, warehouses, offices and industrial units. How these markets move is different but the objective for the investor is the same: obtain an attractive and hopefully rising rental income and some capital growth over the long term – potentially outpacing inflation.

Performance has been poor for many of the generalist property funds in recent years, particularly those with lots of retail properties as increased internet shopping put has pressure on high street. Areas with overcapacity are less likely to make a good inflation hedge due to the structural challenges. However, other areas such as warehouses, logistics, data centres and healthcare property could be more resilient, albeit valuations among the specialist investment trusts operating in these areas are more expensive.

Meanwhile, infrastructure assets often have a certain amount of contractual inflation protection built in. They can potentially provide investors with an attractive, income-orientated return and welcome diversification from equity markets. There are a number of fund and investment trust options for investing in this specialist area, which looks relatively well placed to generate consistent returns.

Gold

Gold tends to divide investor opinion. It often becomes the go-to asset in times of crisis, or when fears persist that interest rates on paper money aren’t enough to compensate for inflation. It has, after all, been a store of value for millennia. However, it has no intrinsic value beyond some limited industrial use, and it accrues no returns. In the short term, gold doesn’t always work as an inflation hedge, especially when interest rates are rising too, and it can be very volatile. Yet it does provide diversification and it tends to maintain its spending power over long periods of time.

It is possible to buy exposure to gold via an exchange traded fund (ETF). We tend to prefer ‘physically-backed’ funds which own gold kept securely in a vault, as opposed to derivatives-based funds where there is added risk and complexity. One example is iShares Physical Gold.

Another route into gold is through shares in gold mining companies. These tend to represent a ‘geared’ play on the gold price, meaning that they multiply the effect of a rise – but also multiply any fall. This is because profits can be highly sensitive to what the gold price is doing, and the riskier firms could even swing from profit to loss or vice versa on bullion’s moves. The fund on our Direct Investment Service Preferred List dedicated to this area is Blackrock Gold & General, but given the high level of risk involved we would suggest it is only held as a small proportion (e.g. less than 5%) of a diversified portfolio.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

How could higher inflation affect your investments?

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