Portfolios for a high inflation environment

Please note this blog post was published over 12 months ago and so may not include the most up-to-date information, for example where regulation around investing has changed.

Portfolios for a high inflation environment

Inflation erodes the purchasing power of cash-based deposits over time and this is why asset backed investments are favoured by long term investors. Having a portfolio containing assets that can grow has historically been a very effective way to offset the effects of inflation on capital. In this article, we explore how we can position multi asset portfolios for periods of high or rising inflation.

Central banks have stated that their primary objective is to hold inflation at or around 2% per annum. Currently we are seeing year on year inflation at 4 to 5 times this target which has forced most central banks to increase interest rates at a faster rate than was anticipated at the start of 2022, particularly in the US and UK. Given the ‘tightening’ policies we see continuing into the second half of the year we have many choices to consider when constructing our portfolios.

Starting with government bonds, traditionally stable investments offering steady income to maturity. As interest rates are increased to cool down economies the attractiveness of the fixed regular income falls, lowering the value of the bond in the market. Those bonds with longer to run to maturity (the term for this period is often referred to as ‘duration’) are less attractive as the return is locked in for longer during times when interest rates are due to increase. Shorter-maturity bonds, where income streams are less impacted by rising interest rates, are much more useful as they are an opportunity to reinvest maturity proceeds and lock into higher rates. We have been reducing the bond duration across our portfolios.

This includes investing in higher-yielding corporate bonds. Other assets such as bank loans and securitised debt instruments have coupons (interest payments) which typically reset every quarter. However, these instruments carry credit risks which we consider in the context of the allocation to all bonds in the portfolios.

Inflation-protected bonds, where the overall return is adjusted upwards by an inflation index, do provide some form of return protection. To benefit in full, they often have to be held to maturity and in these cases the opportunity cost of holding over the longer term is carefully assessed. Finally, floating rate bonds, typically issued by higher-grade companies with coupons adjusted quarterly based on a reference lending rate give us another useful option.

Moving away from bonds, equities historically have performed well during periods of moderately high inflation, as some companies are able to pass inflationary increases on to the consumer in times of normal economic expansion. However, as inflation rises to more extreme levels it can be harder to transfer price increases. Persistently high inflation has triggered the current aggressive monetary tightening by central banks. In such an environment, not all companies can pass on all increased input costs.

Companies with distinguished products and services are better placed to protect their revenues in a rising inflation environment. They find it easier to pass on costs to consumers making their revenues less sensitive to changes in demand. These businesses may be defined as defensive and/or value oriented, typically exhibiting lower sensitivity to rising interest rates than the broader market. These businesses also can pay out a larger share of profits as dividends.

Active management of the portfolios means that we can place an onus on buying value orientated equities in the portfolios whilst still holding those growth stocks that have served us so well in the past.

Alternatives are another asset class which covers a broad range of investment opportunities including real assets such as commodities, property and infrastructure. Historically they have provided some protection against inflationary shocks. Gold, oil and industrial metals have been good investments to hold during periods of rising inflation. Real estate also provides protection, as many longer-term leases have inflation-linked uplifts. Accordingly, our allocation to alternatives has been increased over the course of the last 12 months.

The era of ultra-low inflation and interest rates appears to be behind us for now. It is prudent to review asset allocations to assess appropriateness in both higher inflation and more normalised interest rate environments.

Active management is very important today. Being able to select where to invest and how long to hold assets is at the core of our investment approach as we build diversified portfolios designed to help our clients reach their investment goals in the years ahead

With investing, your capital is at risk. Investments can fluctuate in value and you may get back less than you invest. Past performance is not a guide to future performance. Tax rules can change at any time. This blog is not personal financial advice.