We are now in a cycle that many investors in Western Europe and America may be experiencing for the first time in their lives – a sustained, ongoing inflationary trend. We see inflationary pressures in the EU, UK and US set multi-decade highs. Despite earlier forecasts, it has remained stubbornly high over the past 18 months, which in turn lowers the standard of living and eats away at wealth and purchasing power.
The post-pandemic economic recovery forces the Bank of England to raise rates and end super-cheap money in the face of rising inflation
Here in the UK, as we enter the new tax year, the situation must be seen against a background of a UK fiscal monetary policy ‘double action’ – large spending and very low interest rates. As we enter the new tax year, the inflationary situation must be seen against a background of a British fiscal monetary policy ‘double action’ – large spending and very low interest rates. This has boosted asset prices. Now the post-pandemic economic recovery is forcing the Bank of England to raise rates and end super-cheap money in the face of rising inflation, forcing the government to strengthen budget balance sheets. Medium-term budgets are typically ‘hair shirts’, designed to leave room for broader policies near an election.
This is the case with the recent Spring Declaration, with an announcement of limited government support (and far less than some commentators and the opposition would have liked). This is the case with the Spring Declaration, with an announcement of limited government support (and much less than some commentators and the opposition would have liked). As inflation exceeds 5% in the UK, investors need to consider both short- and long-term impacts when making investment decisions.
Implications for investment decisions
First, it is worth examining why investors should try to bring inflation expectations into investment considerations. After all, both economists and investors have a weak record of accurately predicting large shifts in inflation. Rather than trying to choose an exact target, it is generally better to look at inflation in terms of probabilities of different trends. It was more profitable to maintain a stock focus and identify undervalued assets that were priced to yield higher returns, than to bet on a specific inflation scenario. What is the chance of ‘high’ inflation based on what we know today? And then act accordingly.
The current situation is similar to buying flood insurance in the middle of a flood – it’s much worse than doing it before the water starts to rise.
Gold, commodities and inflation-linked bonds are traditional bulwarks against inflation. It has shown some usefulness in this current crisis, but in most cases has already ‘paid out’ and now has relatively high prices. The current situation is similar to buying flood insurance in the middle of a flood – it’s much worse than doing it before the water starts to rise. For investors, these types of products will not be as useful as a hedge in this cycle. There is not a strong argument for this in portfolios today. The one exception may be energy stocks due to short-term pressure and previous undervaluation.
Build in protection
Rather than explicit inflation protection, a more reliable way to maintain and grow wealth is to build a diversified portfolio that is biased towards discount markets. Build a safety margin and add diversifiers so that it can perform in a variety of economic and market conditions. Investors are not as good at finding market tops and lows as they believe. Morningstar’s research on flows consistently shows that investors detract from value when switching to and from funds. In short, the assessment of market timing allows investors to do worse.
Investors are not as good at finding market tops and lows as they believe.
Diversification starts with stocks. Equities remain the most reliable source of long-term capital growth and outperform inflation in most regimes. Equities remain key to helping investors achieve their investment goals, to raise capital in their working lives and to ensure that their savings last longer and can generate income that can increase over time.
At the moment, we see British, German and Latin American stocks as excellent options. At the moment, we see British, German and Latin American stocks as excellent options. Financial and emerging market debt are also attractive. For diversifiers, we suggest looking at high-quality companies with price power to deal with further inflation shocks and high-quality government bonds for slowdown, recession and shock scenarios. We currently see US government bonds and the yen as ‘risk-off’ diversifiers for when corporate profits are at risk.
Inflation does not have to jeopardize returns, with the right preparation and adjustment it is possible to create a portfolio designed to withstand current market conditions.