InvestmentsSep 1 2017

Choosing the best inflation-busting investment strategies

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Choosing the best inflation-busting investment strategies

Investors have been keeping a close eye on UK inflation since it peaked at 2.9 per cent in May. 

Tthe Consumer Price Index (CPI) measure of price growth has since levelled off at 2.6 per cent in June and July. But there are many who continue to think that it could hit 3 per cent by the end of 2017.

The rises may have come as a surprise to investors who had grown used to several years of subdued prices. While it is not at the 5 per cent level briefly touched in 2012, CPI inflation has now been above the Bank of England’s 2 per cent target for six months. 

With investment returns harder to come by now than they were five years ago, the challenge of how to beat price rises remains a tricky one, not least because many of the instruments are an imperfect match. 

Typically, asset classes such as equities, commodities and gold have been used by advisers and their clients to protect against rising inflation, in addition to perhaps the most obvious defence: inflation-linked bonds.

But these are not proving as effective as they have been in the past. 

As Will McIntosh-Whyte, assistant fund manager at Rathbones, points out, inflation-linked bonds – like most government bonds – are expensive. 

“Added to that, buying these assets means you take on even more duration, or sensitivity to interest rates, than their conventional gilt counterparts due to the lower coupons on offer,” Mr McIntosh-Whyte explains.

“At the moment, you would need inflation to average 3 per cent each year for the next 10 years to outperform plain-vanilla gilts, which are negative in real terms anyway because inflation outstrips the yield they offer. 

“You would be taking on a substantial amount of interest rate risk to gain this protection, and if you were right, chances are that the Bank of England would be raising rates to dampen inflation, so the loss would hurt you potentially more than you stand to gain.”

Indeed, UK inflation-linked bonds have posted negative returns since the end of October 2016, despite CPI inflation rising from 1 per cent to its current level since then.

George Efstathopoulos, multi-asset portfolio manager at Fidelity International, suggests that more complicated techniques must be employed to safeguard portfolios without being exposed to interest rate risk.

“One way to mitigate the duration impact is to invest in inflation breakeven instruments – an area we have recently witnessed with the launch of exchange-traded funds (ETFs). 

“While ETFs aim to provide a better outcome for investors wishing to hedge against rising inflation, we should note that they require additional due diligence due to the use of more complex derivatives.”

Metals and miners

Gold is generally considered to be a flight to safety in times of uncertainty, with investors piling into the precious metal once again when tensions between North Korea and the US rose in August. 

However, there are some doubts as to whether bullion protects investors against price rises elsewhere.

Tommaso Mancuso, head of multi-asset at Hermes Investment Management, says: “Empirical evidence shows that gold is in fact a poor hedge against inflation. It tends to move more in line with fear of inflation. In other words, timing is key and when inflation hits the headlines, it is generally too late to pile into gold.”

The other issue with gold is while it is known as a store of value, its exact value at any given time is very hard to determine.

Scott Gallacher, chartered financial planner at Rowley Turton, is no fan of the investment.

Mr Gallacher reasons: “Gold is often lauded as an inflation hedge. However, while I’d accept that it’s a hedge against economic uncertainty and the prospect of rapidly rising inflation, it’s a very volatile investment and has poor protection against ‘normal’ inflation.”

He adds: “Historically, national savings index-linked certificates were the perfect hedge, but unfortunately these are no longer available. Although existing holders can renew them over, the return is now only 0.01 per cent above RPI.”

Other commodities have also had a reputation for being a useful inflation hedge in the past, as changes in raw material prices are an important driver of inflation. 

“But commodities can also be a very volatile asset class, such as with the approximate 75 per cent decline in the oil price from June 2014 to its lows in early 2016,” Mr Efstathopoulos notes.

Elsewhere commodities including crops such as wheat are often at the whim of weather conditions and supply and demand factors, with prices likely to fluctuate considerably.

“Buying a basket of futures (such as an ETF) for the raw materials of commerce – wheat, oil, coal and ore – means you should benefit from the uplift in the economy’s price level,” Mr McIntosh-Whyte advises. 

“A broad spread of different commodities reduces these value swings somewhat, but our research shows that prices don’t always keep pace with inflation when CPI is notably high. Also, it is important to know exactly what you’re buying. There are myriad structures and strategies for commodity ETFs and few are simple.”

The old favourite

This leaves equities – the preferred asset class among intermediaries and one that has delivered soaring returns over the past decade.

“While accelerations in inflation can be bad for equities in the short term, we believe companies with strong pricing power can pass on cost increases to their consumers, mitigating the effect of rising prices,” Mr McIntosh-Whyte points out. 

“Some, if they are dominant enough in their industry, can use their muscle to defend against price pressures in their supply chains, too. Businesses in this happy position tend to be those growing regardless of wider GDP growth, and with a product or service with few competitors, or none.”

Investors may want to look further afield for their equity exposure than they have done in the past. US equities (the S&P 500 index) are particularly notable in having returned 7 per cent above inflation from 1950 to 2009, Mr Efstathopoulos says.

The balance between capital growth and income has not proved that difficult for investors since the financial crisis. Investment growth has been accompanied by record levels of dividend payouts – in the UK at least. 

But just as market valuations are now looking toppy, there are additional challenges on the horizon for dividend stocks.

“Equity income funds can be vulnerable in a rate rising environment as the market reassesses their valuations,” Mr Efstathopoulos explains.

Ultimately, the perfect inflation hedge does not exist. Instead, the most effective approach is simply to ensure investments are well diversified. Box 1 details some of the options available.

Mr Mancuso acknowledges: “As the drivers of inflation change over time and each asset’s relationship with inflation can vary with the prevailing macro environment, rather than relying on one single tool, the sensible answer is to combine different inflation-sensitive assets and manage such a portfolio dynamically.”

Mr McIntosh-Whyte adds: “Investors must consider with each hedge everything from how it correlates to other assets; how it will react to different scenarios; the probability of those scenarios and how much you have to pay for it. 

“Arguably, the best hedge is a well-constructed portfolio.”

Box 1

FundCalibre MD Darius McDermott’s fund picks

To beat inflation, finding a bond fund with a higher yield to compensate for higher inflation will be key. GAM Star Credit Opportunities is worth a look with a yield of 4.53 per cent, as is Schroder High Yield Opportunities with its 6 per cent yield.

Some property funds, such as Henderson UK Property, also have underlying leases linked to inflation More generalist UK equity funds that have a nice level of yield may provide that all-important buffer. For example, Fidelity Enhanced Income (6.26 per cent).

No one asset class is the solution, so a diversified portfolio with a combination of the above ideas is probably the way to go. F&C Navigator Distribution is a multi-manager fund with a yield of 4.4 per cent.

Ellie Duncan is deputy content plus editor at FTAdviser.com