How could higher inflation affect your investments?

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.

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.

How you can combat inflation in your portfolio

1. 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.

2. 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.

3. 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.

4. 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.