Inflation hasn’t been a severe or persistent economic problem for more than a decade thanks to prudent monetary and fiscal policies, but now price volatility is picking up again.
Investors need to understand the strategies that will best protect their portfolios against inflation because the wrong choices can decimate the value of any investment portfolio or pension. As the late Margaret Thatcher once said: “Inflation is the parent of unemployment and the unseen robber of those who have saved.”
I had to go back at least 20 years to find good research on investing during periods of high inflation and guidance on which assets have historically provided investors protection against escalating prices.
Reliance on history and research
Before continuing I need to make it clear that I’m unable to forecast the outlook for inflation with any certainty. If I did, I’d be a billionaire. But I believe we are entering a period where prices will be more volatile, and perhaps higher on average, than what they have been over the past 20 years. Global money supply has grown substantially in the years since the Global Financial Crisis of 2007/2009, and further rapid expansion has been facilitated to offset the economic damage wrought by Covid-19.
In fact, inflation should perhaps be higher than it is now, based on classic economic theory. Still, that could be the lag effect as the increased money supply filters through the global economy. Therefore, accelerating inflation should be of significant concern because of the dire consequences that may ensue when interest rates rise in a world that is awash with debt and liquidity. Investors may have to reposition their portfolios to be better prepared should current fears prove justified.
How does inflation affect the various traditional asset classes?
- Bonds: The conventional wisdom that government debt has historically proven to be a poor (or an unfavourable) hedge against inflation shocks is correct. From a theoretical perspective, an increase in interest rates caused by the rise in inflation expectations causes bond prices to fall: the expected inflation embedded in the yield increases, and the bond price usually drops. If the new level of expected inflation is permanent, longer-dated bonds will be more sensitive than those with shorter maturities. In lay terms, bonds may be the worst place to invest if unexpectedly high inflation becomes a reality.
- Equities are more complex, as higher inflation can have differing effects on different stocks. First, firms with market power can pass on the higher prices to mitigate their impact, and their profit margins can remain stable or even expand. But not all companies will have this level of bargaining power, so an investment in an equity-market index may not give investors the inflation hedge they desire. And suppose the period of high inflation is followed by economic weakness. In that case, expected future cash flows will decrease, leading to a decrease in company valuations. Second, growth stocks that promise dividends far in the future are susceptible to increased discount rates that result from changing inflation expectations. We have already seen this effect at play globally, as tech stocks have taken a beating over the past 12 months. Still, equities have historically proven to be a better inflation hedge than bonds.
- Commodities are often the source of inflation. They are mechanically related to inflation rates, at least in the short term, because they are part of the inputs used to calculate the consumer and producer price levels. Most research indicates that commodities perform best during high and rising inflation periods, similar to the environment we find ourselves in today. High inflation may have a silver lining for commodity-exporting countries like SA in the form of higher tax revenues, a strengthening currency, and healthier government finances. But while there is a positive correlation between commodities and inflation, commodity prices are highly volatile. They shouldn’t be used as a hedge against inflation but rather only as a small part of a much broader portfolio strategy.
- Short-term interest-bearing instruments were a classic inflation hedge, closely tracking inflation over most periods until the global financial crisis of 2008. The reality now is a brave new world of manipulated interest rates. There was no identifiable emergency between the end of the Global Financial Crisis and the beginning of the Covid pandemic — more than a decade of global interest rates being kept artificially low. Thus, it has become risky to hedge inflation using these short-term instruments despite a long history of past success.
In conclusion, inflation is a silent killer. It is very difficult to diagnose whether what we see is a temporary shock or something more permanent. And by the time we have clarity, it will be too late for many investors. To protect a portfolio against inflation, investors need to keep a close eye on their bond component while being very selective in their choice of equities and commodity exposures. Cash may not be the reliable inflation hedge of old. Times have changed and investors must be more vigilant.
• Ndinavhushavhelo Rabali is chief investment officer at Lima Mbeu.
Would you like to comment on this article?
Sign up (it's quick and free) or sign in now.
Please read our Comment Policy before commenting.