A little inflation is deemed to not necessarily be a bad thing, however more than a little can be rather a different beast. So much so that inflation has been described as “…the parent of unemployment and the unseen robber of those who have saved”, as well as being “…violent as a mugger, as frightening as an armed robber and as deadly as a hitman.”.
Having been mugged many years ago, it certainly did hit me in the wallet (it was stolen), but perhaps not in the same as way as former US President Ronald Reagan meant in the second quote above.
For investors, inflation chips away at those nominal gains, reducing their purchasing power. For investors to generate real returns therefore, returns must first beat the rate of inflation, something which doesn’t seem too difficult when inflation is 2%, but when it’s 10%, it’s a rather different matter.
Spoiler alert - while the next few paragraphs will unfortunately give no special insight into how to generate inflation-busting returns when UK CPI is as high as it currently is, there are some asset classes that can provide more protection than others in the face of higher inflation.
As many clients and investors will know, multi-asset funds typically invest in a broad range of asset classes, from cash and bonds to equities and property, as well as alternatives such as infrastructure, commodities, hedge funds and private equity. This means they typically have the flexibility to seek out investment options that a fund focused on a single asset class funds may not.
Inflation is most damaging to the value of fixed interest securities such as bonds. Holding a bond with a 5% coupon? Fine when inflation is 2% and your real return is 3%, but inflation at 10% then not so good. However, inflation-linked bonds are a different story as when inflation rises, so does the value of the bond. Other instruments where the returns are linked to a floating rate can also offer some protection against inflation.
Investing in equities for the long-term should help a diversified portfolio maintain its purchasing power over time. However, when inflation is high, some sectors fare better than others, with those able to pass on rising input costs to consumers, such as food and drinks companies, likely to perform better than those that can’t, or at least when consumers can afford to pay those higher prices.
Property is a popular choice as an inflation hedge as property prices and rents tend to increase as landlords demand higher returns to offset their higher costs. However, property capital values are vulnerable to rising interest rates, something which typically goes along with higher inflation, particularly when economic growth is weak, so any potential inflation hedge may only be partial at best.
Tangible assets such as commodities are often popular investments in times of higher inflation. Gold remains a key commodity investment considered to offer some inflation protection, but as well as precious metals, raw materials and agricultural products are also very popular as prices rise alongside the prices of finished goods made from those commodities. Just look at the recent rises in the price of natural gas to see what returns could be.
Other real assets may also perform well in times of higher inflation. In the infrastructure space, many assets have inflation protection built into the contracts and are therefore able to pass on those higher costs to the end customer, meaning that investors benefit from the automatic uplift in revenues as the rate of inflation increases. However, those assets with more limited ability to pass on higher costs may fare less well.
As stated earlier, while there is no magic bullet to investing in a way to keep pace with any level of inflation, the ability of multi-asset funds to actively invest across asset classes may offer some help by the fund manager being able to seek out and, hopefully, take advantage of opportunities where those assets can provide a degree of protection and therefore take less of a hit to those all-important returns.
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