Investment management is simple but not easy, especially during the periods of high inflation like we are currently experiencing after the Covid-19 pandemic and the resulting supply-chain disruptions. Understanding inflation is important for investors as it erodes purchasing power and reduces the investment value. Inflation impacts economies from all corners as rising prices discourage consumer spending, which ultimately impacts business activities, profitability, employment, taxation and other government policies, and interest rates. It is at highest levels (8.5% in US and over 10% in UK) in last four decades and still central banks are taking contractionary approach to increasing interest rates to combat rising prices. Therefore, it is crucial to understand what inflation is, what are the factors causing high inflation, how it impacts investment portfolios, how best to invest in inflationary periods, and what are the sectors and assets which perform well during periods of high inflation.
Inflation is an increase in prices of a basket of commonly used essential goods and services in the economy. Consumer Price Index (CPI) is a commonly used benchmark to measure inflation (increase in prices) over the previous period. Economists normally use two types of inflation as follows to understand its causes and effects:
• Demand – pull inflation occurs when there is more demand of goods and services than the available supply, therefore, prices start increasing.
• Cost – push inflation occurs when costs of manufacturing goods and services increases as a result of an increase in input prices, therefore, the manufacturers must increase prices of final goods and services to remain going-concern entities.
Current inflationary momentum looks a result of both demand-pull inflation and cost-push inflation. It started its pace with the excessive liquidity (trillions of dollars) injected by the central banks, especially the US Fed, in the economy to provide a much-needed boost when the pandemic hit, and countries went into lockdowns to minimise the spread of virus. These expansionary moves caused the prices to increase as “too many dollars were chasing too few goods”. Later it turned to more cost-push inflation when energy and commodity prices skyrocketed, and supply-chains disrupted due to the pandemic-driven lockdowns. Still the inflationary environment is an ongoing phenomenon, and the central banks are looking after it by taking a hawkish approach to bring the inflation back to 2% normal level. Will they be able to bring it back to that level and how much time it will take? Difficult to envisage.
Then the question arises: how best to manage investments to minimise adverse impact on portfolios, and what are the sectors and assets that do well during inflationary periods?
A prolonged period of high inflation is not good news for investors because it erodes investment returns and negatively impacts the value of investment portfolios. However, holding on cash is not always an optimal strategy. The value cash loses (decreasing purchasing power) in high inflationary periods is unlikely to be recovered. Therefore, investing cash in return generating quality investments, as opposed to putting it under a mattress or in bank accounts is prudent for long term investors as any loss in value of an investment has the probability to recover when that asset value increases or other assets in the portfolio increase in value. A well-diversified portfolio is the best way to go in an inflationary environment as different assets behave differently as illustrated below, and at different times they can change their generally perceived behaviour.
Asset classes performance in inflationary periods
The following assets could be part of a well-diversified investment portfolio in high inflationary period.
Equities
Holding stocks offers a proportional ownership in publicly listed companies. Equities offer a wide range of opportunities for investors as there are many sectors in the economy that equities represent. Some sectors provide better hedge against inflation during periods of high inflation than other sectors. For example, Energy, Consumer Staples, Utilities, and Precious Metals and Mining sectors are a better choice in high inflation periods as illustrated below. On the other hand, Consumer Discretionary, IT, Mortgage REITS, Telecoms, and Materials provide lesser protection against inflation. Moreover, value stocks have performed better than growth stocks historically, on average, during periods of high inflation as highlighted in the chart above. Historically, equities have outperformed all other asset classes over the long-term and have outpaced the inflation significantly.
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Sectors and inflation-adjusted performance
Commodities and Precious Metals
Commodities and precious metals include many assets like gold, silver, base metals, natural resources, grains, etc. Many of commodities and precious metals’ assets are critical in the economic production cycle, therefore, their values increase, generally, during periods of high inflation and uncertainty. This asset class is generally considered as a safe haven for investors as they have negative or low correlations with other asset classes (i.e., equities and bonds) and provides a natural hedge against inflation. However, commodities are disadvantaged as compared to equities as they do not pay any dividends.
Real Estate
Real estate, especially commercial real estate, is another asset class that increases in price during high periods of inflation. Any property that generates periodic rents or lease payments falls in commercial real estate including offices, industrial facilities, homes, apartment buildings, storage spaces, etc. Real estate provides hedge against inflation as rents and property values increase in an inflationary environment, therefore, a portion of portfolio investments allocated to real estate may provide downside protection.
Bonds/TIPS/Sukuks
Unlike equities, bonds/sukuks provides fixed income periodically over the investment horizon while seeking to protect principle invested in these assets. Short duration bonds become more attractive as compared to long duration bonds given increase in interest rates following high inflation. Inflation-linked bonds (i.e., TIPS) become more attractive in an inflationary environment. Values of bonds decrease as interest rates increase, and values of long duration bonds decrease more than the values of short duration bonds as interest rates increase. Investors tend to follow the yield and prefer short duration high-yield bonds and avoid high uncertainty embedded in long duration bonds during periods of high inflation. At Simply Ethical, we do not invest in interest bearing instruments like bonds or TIPS. However, we gain exposure to fixed income asset class by investing in a portfolio of Sharia compliant sukuks.
In summary, inflation brings many challenges as well as opportunities for investors. Being invested in a well-diversified portfolio provides the best hedge against high inflation. Equities outpace the inflation over the long run, and commodities, real estate, and bonds/sukuks provides diversification and downside protection in an inflationary environment.
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Disclaimer
Past performance is not a reliable indicator of current or future returns. This overview contains general information only and does not consider individual objectives, taxation position or financial needs. Nor does this constitute a recommendation of the suitability of any investment strategy for a particular investor. It is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any trading strategy to any person in any jurisdiction in which such an offer or solicitation is not authorised or to any person to whom it would be unlawful to market such an offer or solicitation.