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There has been a lot of talk recently about inflation and how it may affect consumers & investors. Within this blog, we cover what inflation is & how different asset classes are likely to respond in an inflationary environment.
Inflation is an economic term that refers to the increase in prices of goods and services over time. When measuring inflation, analysts commonly look at the rise in essentials such as food, clothing & transportation. Over time, things generally increase in price, this is inflation. Steady inflation is generally seen as a good thing as it encourages consumption & investment, as delay, will cause things to become more expensive. However, when inflation accelerates at too great a speed, problems can occur. And it is the speed at which inflation is currently predicted that is spooking investors, especially equity investors.
Below we explore how different asset classes are likely to respond in an inflationary environment. Should you wish to speak with an expert about your portfolio please click on this link to book a meeting.
An investor who believes current price rises are temporary, and the temporary side-effect of a strong global recovery, may prefer to sit through a period of rising prices in equities. If, however, one believes that a prolonged period of structural inflation is about to hit the global economy -especially if wages start to rise- then real assets, gold, cryptocurrencies and inflation-linked bonds might be a better approach. A multi-asset fund manager will be constantly weighing up the pros and cons of various assets as regards inflation. The following is a brief description of how different assets might respond:
The traditional hedge against inflation is to use assets that are grounded in the ‘real world’, such as property and commodities. Within commodities, gold is perhaps the best-known inflation hedge, but many professional investors are also eyeing copper at present because so much green energy requires copper cabling and components. These are physical assets that you can touch, that actually exist, and for which man has always had a need for. They do not represent someone else’s liability (a ‘financial asset’).
Privately issued cryptocurrencies are not physical, and not generally held by multi-asset fund managers, but they may also be an option for some investors. They offer independence from the risk of central banks’ creating too much money, while some actually guarantee a diminishing fresh supply over a long time (eg, Bitcoin).
The classic ‘financial asset’. Since bonds are based on someone’s promise to repay a fixed sum -in interest payments as well as capital- they have not stood well against inflation. Rising prices shrink the inflation-adjusted real return of the payments. But interestingly the riskiest parts of the bond market, high yield and emerging market debt, can benefit from inflation if credit rating agencies re-rate the debt because it is cheaper for the borrower to service. This is most apparent to an investor that sees a high yield bond jump a notch into the investment-grade category.
A more reliable way for fixed income investor to protect themselves from inflation is through using inflation-linked bonds. However, these are much sought after at present and do not offer real value, as judged by the so-called breakeven rate. This is calculated by subtracting the yield on a government bond by the yield on an inflation-linked bond of the same maturity. For example, the 10 year Treasury breakeven rate is currently 2.53%, which means investors believe this will be the average inflation rate over the next decade. This seems unrealistic, given the structural deflationary forces (eg, demographics and automation) at play. But of course, for an investor who thinks a major structural inflation problem is around the corner, a breakeven rate of 2.53% may appear a bargain.
Equities are a diluted form of real asset: a company can raise its prices in a period of inflation, and so maintain the real value of the dividends and the worth of the company. Indeed, financial history shows that equities perform relatively well in periods of low to moderate inflation. But there is an element of promise in an equity, such as the promise of the company to share its profits through a dividend, and profit margins are at risk if input costs also rise faster than selling prices can be raised.