Prices for daily essentials, such as fuel, food, clothes, transport, are rising faster still. Incomes, by contrast, are static at best and interest rates for savers are offensively low.
Growth investors can make long-term strategic decisions to ride out inflationary periods, but income investors are vulnerable. They need immediate returns and, if they are to sustain those returns in the long term, they need to maintain the value of their capital.
A multi-asset investment approach provides opportunities and strategies for ‘natural hedges’ against inflation, allowing fund managers to preserve capital and sustain income levels. But before we can think through strategies for coping with inflation, we need to understand its causes.
No two inflationary cycles are the same. In the German Weimar Republic in the 1920s the Reichsbank printed money in order to destroy the value of reparation payments imposed by the Treaty of Versailles. In the 1970s oil prices were forced up by an international cartel of producers.
In our own time it is different again. For many years, from the early 1990s until the 2008 credit crisis, the integration of emerging markets into the global economy helped to suppress prices. Goods from China were cheaper, as were services sourced from India. The rise in oil prices that accompanied the long economic expansion through this period was largely absorbed through superior technology, improved resource management and better use of alternative fuels, particularly natural gas. New producers, such as Russia, further helped contain prices.
These same factors are now in reverse. Emerging markets are now the source of rising prices, both in the raw materials used in capital investment and in the basic foodstuffs and consumer goods increasingly in demand by their rapidly growing middle classes. Advances in the technology and management of energy consumption have slowed, while new production, such as the deep-water wells in the Gulf of Mexico or plans to drill in the Arctic, is becoming ever more expensive and higher risk, as in the .
What this is telling us is that inflation is likely to be deeper rooted and more persistent than in earlier periods. We may not – we are unlikely – to see the double-digit inflation of the 1970s or the hyper-inflation of the 1920s, but there is no single, simple source to the problem. We should also recognise that our own authorities, the Bank of England and the Treasury, are strikingly limited in the responses open to them. Developed states, individually or collectively, simply do not have the tools or the influence to seriously impact global prices. Inflation at current levels could last for many years. As investors we need to take control of our own destiny and create appropriate strategies to preserve capital and continue to secure consistent levels of income.
We can of course buy index-linked bonds. These offer a coupon plus inflation, as measured by the consumer price index. The risk with ‘linkers’ is that they are essentially a form of gilt, or UK government debt, which has been extremely expensive for a number of reasons including acting as a safe haven from the euro, due to the Bank‘s quantitative easing, or their use as liability matching assets by pension funds. While linkers may form part of an overall strategy, I do not feel they are sufficient in themselves.
One tried and tested alternative, in a multi-asset approach is to adjust allocations to equities more generally. Equities represent ownership of companies and equity valuations reflect profits. Companies may suffer in the early phases of an inflationary cycle as they pay more for materials, but in time they will raise their own prices, protecting profits and therefore capital value and dividends.
Another response is to buy the commodities that are at the source of global price increases. At a basic level the price we pay for petrol at a garage in the UK reflects the price refineries are paying on the international spot market for crude oil. If we own exposure to the latter it will help to balance our need to pay more for the former. We do not need to buy actual barrels of oil as owning a future on index priced off Brent crude will have the same effect. We can take similar positions with other commodities, such as metals or agricultural products.
A third strategy is commercial property. Because leases are written for very long periods of up to 20 or 25 years they frequently have built-in, upward-only periodic rent adjustments. The precise amount any particular increase tends to be up for negotiation whenever the adjustment falls due, but inflation tends to be the benchmark. Some managers prefer to buy funds which own actual buildings, rather than those that own property company equities or real estate investment trusts, as they feel the risks of direct ownership are more transparent.
Finally, an interesting way to cope with inflation is through infrastructure. Once these assets – rail, roads, ports, pipelines and postal services – are created they often have high longevity. In many cases they have minimal demand sensitivity, not least because they are often natural monopolies. Whether or not they are directly regulated, their pricing tends to be linked to inflation.
The current phase of inflation may last a long time but a robust, diversified multi-asset approach provides a number responses which, in my view, can help to preserve capital and sustain income.
John Ventre is head of multi-manager of Old Mutual Global Investors
Key points
A multi-asset investment approach provides opportunities and strategies for ‘natural hedges’ against inflation.
Emerging markets are now the source of rising prices, both in the raw materials used in capital investment and in the basic foodstuffs and consumer goods.
An interesting way to cope with inflation is through infrastructure.
