Inflation is dominating the economic outlook. The twin drivers of a supply-side squeeze and catch-up in demand, combined with specific Brexit factors, have seen prices surge across Britain.
UK inflation is now set to hit five per cent next year.
Meanwhile, across the pond, inflation has hit a 30-year high. US core inflation, which excludes the most volatile components of the consumer basket, such as food and energy, has rocketed 4.6 per cent annually. Those are the sorts of numbers that would have been unheard of pre-pandemic, and indeed, even 18 months ago, the notion that sharply higher inflation would be the issue would have seemed unlikely.
As global fuel and grocery prices rise, any wage gains are being eroded, raising the dreaded spectre of stagflation. Stagflation is the concept of inflation rising at the same time as economic growth is declining, and turns negative. There are sharply divergent views among market participants as to whether stagflation is likely in the UK.
While politicians are trying to assuage concerns of ordinary voters suffering at the pump – dismissing rising prices as transitory – the data indicate inflation could become more entrenched.
Although the Bank of England is clearly leaving room to manoeuvre, the question is how hot central bankers are prepared to let the economy run before intervening and raising interest rates. Given the risk of a policy error and the damage structural inflation could do to portfolios, it seems sensible for investors to look for ways to inflation-proof at least some of their exposures without sacrificing growth.
Fortunately, investors can access a number of strategies that will help insulate portfolios from the harmful impact of an inflationary environment. Below are some ideas of the options available for multi-asset investors who are concerned about the potential for higher inflation to dent returns.
Finding value in rising prices
Among the investment styles destined to perform in a rising-rate environment, equity value is an obvious candidate. When inflation is tamer and rates are in a descending or stagnant pattern, investors typically overlook traditional valuation measures in favour of faster-than-average earnings.
This approach hinges not only on the fact that growth is scarce, but also on the fact that low rates tend to raise the current value of expected cash flows in the future. In short, companies that are expected to earn more cash in the future than now do better when rates are low and worse when rates rise substantially.
On the flip side, during periods of inflation and rising rates, company future cash flows are eroded. This puts value stocks, with strong existing cash flows, in the box seat as investors focus on valuations, while blue-sky high-growth stocks feel the gravitational weight of higher discount rates as the cost of borrowing rises.
Growth stocks are those that are often invested in today in anticipation of growth and revenues achieved in future, for example technology companies. The share prices of such companies might be expected to suffer if interest rates are rising, as the income available today from bonds would increase, while if the reason for rising rates is strong economic growth, then it is likely many companies are producing strong cash flows now, reducing the appeal of cash generated in the hypothetical future.