Inflation is the general rise in prices in the economy over time. Central banks worldwide target a low and stable inflation rate. The Reserve Bank targets an inflation rate of 3%-6%. Over the past 20 years, inflation has been unusually low.
In early 2020, the Covid-19 pandemic created havoc in financial markets and destroyed global growth and inflation. Central banks worldwide responded with unprecedented levels of co-ordinated fiscal and monetary policy, which with the rapid development and rollout of vaccines, led to a quick recovery in financial markets. Since then, equity markets have reached new highs and growth has been exceptionally strong.
These developments are positive, but the rise in inflation to multidecade highs has alarmed policymakers worldwide. Annual inflation (CPI) figures for SA were at 7.8% and US inflation at 8.5% in July. With higher inflation higher interest rates are likely to come, which we have already started to see locally and overseas. The economic regime may be shifting away from a higher-growth and lower-inflation regime, towards a falling-growth and rising-inflation regime. A high inflationary environment requires investors to think differently about their asset allocation (the decision to divide your investment portfolio among different asset classes, such as shares, bonds, property and cash).
One of the best ways to combat inflation is to ensure that you remain properly diversified and fully invested.
Investing in shares is generally a good way to outrun inflation as companies are well-positioned to adjust. Most of the time, companies can pass cost increases onto the consumer, thereby keeping their profit margins and share prices intact.
It may be useful for investors to distinguish between the share prices of companies that are expensive vs those that are attractively priced. One way of making this comparison is through value and growth indices. Value stocks are companies that have strong earnings relative to the share price and have robust cash flows, which investors value when prices are rising. Growth stocks tend to be more sensitive to changes in interest rates. The valuation gap between value and growth stocks remains wide globally. With inflation being absent over the past decade, growth stocks have had a stellar performance. Higher interest rates may well be the catalyst causing expensive growth stocks to rerate and reprice. We have already seen this with some of the large technology stocks. Active managers have also fared better compared with passive indices with large positions in large tech stocks.
Concerns investors
Investments in real assets may also improve returns. Real assets derive their value from physical assets such as real estate, infrastructure and commodities. Real estate tends to rise in value during inflationary periods. For most investors, it might be a good idea to consider investing in real estate investment trusts (Reits) instead of direct real estate, which can be expensive and more difficult to access. Commodities, such as gold and silver, have traditionally been good hedges against inflation. They have benefited post Covid-19, and this trend is likely to continue due to the ongoing supply-and-demand imbalances worldwide.
Fixed income (bonds) is probably the asset class that concerns investors the most regarding higher inflation and higher interest rates. This is due to the inverse relationship between interest rates and bond prices. The rule of thumb of “rates up, bonds down” may be an oversimplification of this asset class as “bonds down” only refers to bond prices, which is the smaller and less significant component of the bond return over time. The coupon return (the amount of interest it pays annually) is the more significant contributor to total returns over the medium to long term and should benefit from increasing interest rates. Inflation-linked bonds whose coupon repayments are indexed to inflation can offer excellent diversification for portfolios.
Alternative investments, such as fine art and other collectibles, also tend to make good hedges against inflation. However, this is not always practical and accessible for all investors.
One of the best ways to combat inflation is to ensure that you remain properly diversified and fully invested. Investments in shares tend to outpace inflation over the long term, with real estate, commodities and inflation-linked bonds serving as further diversification. Cash is guaranteed to lose value and long-term bonds may lose value should interest rates rise.
Inflationary periods present an opportunity for you to revisit your financial situation and adjust where necessary. Make sure you have a solid financial plan with appropriate diversification so that your investment portfolio can withstand higher inflation. Consult a certified financial planner to ensure your asset allocation aligns to your goals, time horizon and risk tolerance.
• Bezuidenhout is a director and wealth manager at Netto Invest.
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