Concerns about rising inflation are brewing, particularly in the US. Similar concerns followed the 2009 financial crisis, yet the inflation that was widely expected never materialised.
Equities, bonds, and direct property make up most of a family’s portfolio of investments.
Property is inflation resilient if the rent you receive increases (at least) in line with inflation every year. Equities protect against inflation over the long term if the companies in your portfolio can pass cost increases on to their customers. Bonds, which pay a fixed rate of interest each year, are not resilient as the interest that an investor receives from bonds stays the same, whilst the cost of goods rises. The same goes for cash in a fixed deposit.
If you live off the income (rent, dividends, and interest) from your portfolio, a period of heightened inflation can impact you, particularly if the income from your investments does not increase as the cost of goods and services rise. Even if you do not live off the income from your portfolio, the value of investments that are not inflation resilient may be affected.
To protect your capital through a period of higher-than-average rising prices, your investments need an element of resilience to inflation. For unit trusts, ETFs and direct share portfolios, each fund manager will approach this differently. Some allocate a permanent amount of their fund to investments that are resilient to inflation. Others only do this in certain circumstances or as a secondary thought. It depends on each portfolio managers’ objectives. Therefore, it is important to understand each portfolio manager’s investment style.
To explicitly protect a portfolio against inflation, a fund manager may invest in the following:
- Companies with pricing power
- Real assets
- Inflation linked-bonds
The best example of a company with pricing power is earning income from customers that sign contracts agreeing to inflation-linked price increases. These types of companies are known as real assets. A simple example of a real asset is a property with a 30-year lease, a “AAA” tenant, and contractual rental increases at least equivalent to inflation. Another example is an infrastructure company that owns toll roads, or electricity power plants. Their customers will accept inflationary increases as they cannot easily switch to another toll road provider or another power supplier, nor will they easily reduce their toll road or electricity use. There are funds and ETFs dedicated to investing in real assets.
Gold is somewhat different, as it does not produce an income, but its value increases during times of heightened inflation due to its historical role in society.
Inflation-Linked Bonds are loans to where the interest received increases as inflation increases.
The inflation reported in the media may be temporary, as the world’s demand and supply normalise after the disruption of the pandemic. However, it may be something more serious. We are not worried about runaway inflation of the sort that destroys economies, but the possibility of above-average inflation for a sustained period.
Either way, some explicit resilience to inflation is prudent.