Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.
By most accounts, some degree of inflation is on the horizon. Conditions look ripe: massive fiscal and monetary stimulus packages just keep on coming - Biden’s $1.9 trillion package passed this week in the Senate - and it appears that pent-up demand is just itching to be released once lockdown restrictions ease and economies reopen.
Traditional measures for inflation suggest the same. Bond yields are on the rise - the 10-year US Treasury yield has risen from around 0.9% at the start of the year to 1.6% today, while the so-called five-year break-even rate, which indicates the outlook for prices in five years’ time, last week hit 2.5% for the first time since 2008.
It’s not here yet - we’re still well below our inflation target of 2% - but it’s worth getting to know how inflation typically affects different investments.
There’s no two ways about this: inflation is not good for cash. Money kept under the sofa will find its value eroded as prices rise.
Any kept in cash savings account will stand a better chance - the interest you receive on that cash is likely to increase as prices rise - but ultimately, it’s unlikely to keep up with the rate of inflation.
For many investors, keeping money in cash is a good way to minimise risk and have easy access to your money. Inflation doesn’t negate those benefits, but it does put pressure on your cash. Moving some of that money into ‘money market’ funds is a good middle ground. These invest in highly liquid assets like cash and high-credit bonds meaning that, while riskier than cash itself, they’re considered very low risk with the benefit of offering low levels of income.
Inflation is no friend to bonds either. If prices rise at a rate greater than the interest you earn on a bond, you’ll find the value of your fixed income fall in real terms. Consider a five-year bond paying 2% nominal interest. If inflation rises to 2.5% for those five years, your bond won’t be able to keep up.
That concern is what has fuelled anxiety among bond investors in recent weeks. Inflation expectations are always felt first in bond markets, because it’s the asset with most to lose (besides cash).
However, there are ways to protect your bonds. First, you’re best to avoid long term bonds over short term. That’s because the former are more exposed to changes in interest rates, meaning they have more to lose should they rise (which they invariably do once inflation kicks in).
Second, inflation-linked bonds are one way of keeping your money in fixed income while protecting against inflation risks. The coupon offered on these bonds is linked to a rate of inflation, meaning the interest they pay rises as inflation goes up. Our Select 50 choice of favourite investments includes the ASI Global Inflation-Linked Bond Fund, which looks to protect investors against inflation risk.
The picture for equities is mixed.
First off, inflation is not necessarily a bad thing for shares. In fact, a little bit of inflation is usually a good thing. A ‘goldilocks’ middle ground of 2-4% inflation has historically been best for equity valuations.
But inflation has different implications for different equities. Most notable, it threatens to accelerate a rotation away from high-value ‘growth’ stocks toward of out-of-favour ‘value’ stocks.
Growth stocks comprised last year’s big winners: the tech, pharma and stay-at-home retail stocks whose earnings look set to grow and grow over time. Part of the reason they’ve done so well recently is a low rate, low inflation environment that means the opportunity cost of waiting for their expected earnings is low, while a low interest rate to discount their future earnings increases their value to investors today. An inflationary environment threatens that appeal.
Already we’re seeing the effects of inflation expectations (remember, still only expectations) on these parts of the market. The US Nasdaq index, which is dominated by high growth tech stocks, has fallen by more than 8% in the past two weeks alone, heading towards the 10% definition of a stock market correction. Value stocks, which are cheaper and more cyclical than growth, have outperformed the latter over the past six months.
The temptation at this point may be to jump ship and move all your money away from last year’s winners and back the losers. But caution is warranted. Trying to play the market is seldom successful, and often more trouble than it’s worth. Better to stick with a well-diversified portfolio with exposure to both stories.
Things start to look up now. Commodities have historically outperformed when inflation has picked up. Their relationship is not clear cut though. Rising commodity prices tend to be both a cause and a reflection of inflation. Commodity producers often raise their prices in line with inflation because their cost of production goes up, in turn exacerbating those rises.
Oil is certainly having a good time of it right now. The oil price this week jumped above $70 a barrel for the first time in 14 months - the result of both rising demand and limited supply due to output cuts imposed since the start of the pandemic.
But that’s not true across the board. Watch out for the gold price. Gold is, in theory, a good way to hedge against inflation. It’s kept a fairly consistent value for a few thousand years now. Considering a more medium to short-term view, however, and the picture is varied.
When inflation is driven by rising commodity prices, gold tends to do well. In more cyclical upturns (which this could be) it suffers because people’s risk appetites are higher and interest rates are expected to increase (which is bad for the zero-interest shiny metal). Right now, gold is at its lowest price for nine months. What happens next is too hard to call.
Alternative asset classes like property and infrastructure often do well in times of inflation. Its relationship to the former is clear: as prices rise, so do building costs, and therefore, so do property prices. Rental rates will also typically rise alongside interest rates.
Infrastructure is another potential beneficiary. Most infrastructure assets have explicit linkage to inflation, meaning they tend to keep up with rises. Mark Brennan, manager of the Select 50 FP Foresight UK Infrastructure Income Fund, recently discussed that relationship with us.
Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. Due to the greater possibility of default an investment in a corporate bond is generally less secure than an investment in government bonds. Select 50 is not a personal recommendation to buy or sell a fund. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.
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