Best and worst assets in high inflation

Inflation’s seemingly unstoppable rise is causing major challenges for a wide range of investors. Critically, it has the potential to severely reduce purchasing power. And, with the Bank of England forecasting that inflation will reach in excess of 11% by the end of the year, it could become an even greater problem that proves to be more persistent than previously anticipated.

Higher inflation has already prompted interest rate rises. Further increases in Bank rate seem inevitable, given current inflation forecasts. Indeed, interest rates are expected to reach over 3% next year. Their impact on the economic outlook could be significantly negative at a time when the UK’s prospects have already been downgraded by the IMF. It now expects the UK to be the slowest growing G7 economy in 2023, having recently halved its forecast rise in GDP growth to 1.2%.

Clearly, some assets will fare better than others in this era of high, and rising, inflation. Investors may therefore wish to shift their portfolio towards assets that stand a better chance of growing, or at least maintaining, purchasing power over the coming months. While no asset should be viewed as a ‘silver bullet’ when it comes to inflation protection, prudent asset allocation may prove to be of even greater importance than ever during the current period of rapid price rises.

Equities

The stock market has a long track record of delivering total returns that are in excess of inflation. For instance, the FTSE 250 index has generated an annualised return of around 10% since its inception in 1992.

Some companies will undoubtedly fare better than others in this period of rampant inflation. Firms that are able to raise prices in line, or even ahead of, inflation will clearly offer greater protection against a rapidly rising price level.

For example, tobacco companies, utility firms and businesses with unique products or that have loyal customers due to their strong brands, such as some consumer goods sellers, are generally more capable of passing on higher costs to consumers without hurting demand. Conversely, companies that compete on price, rather than product quality or differentiation, may struggle to maintain profit margins in future.

Of course, the stock market has experienced significant volatility over recent months. Interest rate rises are unlikely to be conducive to a more benign performance – especially since they are generally harmful to the economy’s outlook and, by default, company earnings expectations.

However, investors who are able to take a long-term view of their portfolio and can accept heightened volatility in the short run should feel confident in the ability of a diverse range of equities to grow the purchasing power of their portfolio over the coming years.

Property

Tangible assets such as property have historically offered a worthwhile hedge against high inflation. They can act as a store of wealth, while their rental income may rise at a similar pace to inflation. Indeed, some property rental agreements include a requirement for rents to rise in line with the price level at specific intervals, such as every five years.

Of course, interest rate rises mean the cost of debt is increasing. This is likely to have a negative impact on demand for property and may be particularly acute in the residential sector, where average house prices have risen to a record high compared to average incomes. Meanwhile, a slowing economy, partially caused by higher interest rates, may prompt more difficult trading conditions for firms occupying commercial space. This could weigh on demand and valuations across the sector, while rent rises may become more difficult to achieve.

Nevertheless, the inclusion of real estate investment trusts (REITs) in a portfolio provides welcome diversification benefits during an uncertain economic period. They also offer a relatively sound prospect of maintaining purchasing power while inflation remains rampant. As with equities, though, rising interest rates that contribute to a slowing economy are unlikely to be conducive to high returns from property investments.

Commodities

Commodities have generally had a positive historical relationship with inflation. For example, demand for gold has often risen during periods of rapid price rises due to its status as a store of wealth. Furthermore, the precious metal is widely viewed as a defensive asset that often gains in popularity when the economic outlook becomes more unpredictable, such as during periods of rampant inflation.

The prices of gold and other commodities, such as oil and iron ore, are also affected by interest rates. Gold, for example, becomes less attractive relative to income-producing assets during periods of rising interest rates. Higher US interest rates may also lead to a stronger dollar that makes gold and other commodities more expensive, and therefore less attractive, to non-US based investors. Meanwhile, demand for some commodities may decline in a period where higher interest rates cause a slower pace of economic growth.

Since US interest rates are forecast to rise in the short run, the outlook for commodity prices is highly unpredictable. While they could prove to be relatively volatile, they offer the prospect of inflation-beating performance. Holding a variety of them, including gold, could be a means of improving portfolio diversification and its capacity to retain purchasing power as the rate of inflation rises.

Bonds

While equities, property and commodities offer a significant amount of inflation protection, fixed-income investments face a challenging near-term outlook. As their name suggests, they pay a fixed income on a regular basis. Higher inflation reduces the purchasing power of bondholders’ income, which could leave them materially worse off if the Bank of England’s 11% inflation forecast for the latter part of the year proves accurate.

Bonds also lack appeal in periods of high inflation because of the impact of rising interest rates on their price level. Bond prices and interest rates have an inverse relationship. Therefore, with interest rates expected to rise to over 3% in 2023, bonds should, other things being equal, fall in price. Fixed-income holdings with longer maturities are likely to be more heavily impacted by rising interest rates than short-dated bonds due to their greater number of future interest payments.

Separately, rising interest rates that contribute to a slowing economic outlook could have a negative effect on company performance. This could increase the prospect of default among corporate bonds. Therefore, while many income investors have relied on fixed-income investments in recent years, their capacity to offer an effective hedge against high inflation seems limited.

Cash

With inflation currently significantly higher than interest rates, the purchasing power of cash is deteriorating at a rapid rate. Although higher interest rates are very likely ahead, they may fail to produce a more positive, or indeed less negative, real return because of the likelihood that inflation will rise to over 11% by the end of the year. As a result, holding cash is set to be highly detrimental to a portfolio’s ability to retain its purchasing power in an era of rampant inflation.

Of course, cash can be a useful asset to hold when the economic outlook is highly uncertain. As highlighted, rising interest rates could lead to more difficult operating conditions for many companies. Investors who hold cash may be in a strong position to capitalise on lower valuations among high-quality businesses that struggle to generate growing profits in the short run.

However, beyond its ability to offer greater flexibility than other assets, cash offers extremely limited appeal at the moment. Its lack of scope to maintain purchasing power against high inflation means that investors may wish to limit the size of their cash holdings in the coming months.

See also: The tangible benefits of investing in real assets

Business News