Richard Marwood, senior portfolio manager at Axa Investment Managers, examines where to invest in order to hedge against inflation.
If we look back to the immediate aftermath of the global financial crisis, one topic that polarised market opinion was the inflation/deflation debate. For the deflation proponents, the UK’s slide into recession was just the first step on the path to generalised and sustained declines in both prices and wages.
Despite the best stimulative efforts of policy makers, the combination of ongoing de-leveraging, credit overhang, significant spare capacity and the collapse in consumer demand, meant the UK was potentially facing economic depression.
Conversely, those arguing the inflationary case suggested that the extraordinary measures taken by global policy makers, including accommodative monetary policy and unprecedented quantitative easing (QE) – adding billions in liquidity to the money supply – could only result in inflationary pressure.
A little over 18 months later, and what was a very finely balanced argument has been decided in no uncertain terms – with the inflation-sayers proved correct. Having reached a low in September 2009, UK inflation has risen consistently ever since, breaching the Bank of England’s (BoE) 2%-3% target rate in January 2010 and remaining there ever since. While the threat of deflation has not disappeared completely, the longer inflation remains at these stubbornly high levels, the further the threat recedes.
The Consumer Price Index (CPI) peaked at 3.7% in April 2010. Meanwhile, the Retail Prices Index (RPI), which incorporates housing-related costs including mortgage payments, after falling to negative levels for much of 2009, also peaked in April reaching 5.3%.
The BoE Monetary Policy Committee suggests that the current stubbornly high inflation is a short-term feature, the result of temporary factors such as a rise in energy prices and the re-introduction of the 17.5% VAT rate at the beginning of 2010. Perhaps they are correct.
Certainly, the latest June measures show both CPI and RPI inflation has eased slightly (although still above the BoE’s target rate).
However, to suggest that stubbornly high inflation is temporary, is to ignore the fact that a great deal of the billions in liquidity pumped into the financial system is still yet to reach the wider economy.
Repairing balance sheets
Banks for example, have focused on repairing balance sheets and building their capital strength, thereby limiting the supply of credit to the market. At the same time, consumers have focused on reigning in spending, with de-leveraging and building savings their key priorities. As and when this liquidity eventually begins to feed through the system, further inflationary pressure is likely.
With this in mind, where should you look to invest in order to hedge against inflation and its decimating impact on purchasing power?
The purest form of inflation-protection available to UK investors is via index-linked gilts. As the name suggests, the income and capital value at redemption of these bonds are directly linked to changes in inflation, as measured by the Retail Prices Index (RPI). Guaranteed by the British Government, and so very low risk, they offer stable, real returns above the prevailing rate of inflation, whatever the economic conditions. As such, they are a pure hedge against inflationary pressure, rather than having their returns eaten away, as with other traditional asset classes. When you consider that the June RPI reading came in at 5%, meaning you have to earn at least this from your investment before seeing any positive return, the appeal of index-linked gilts is clear.
A less direct, but perhaps superior investment, given its inflation-beating potential, is equities. This is because, where index-linked bonds keep pace with inflation, equities offer the potential for returns well in excess of inflation. This potential tends to be supported by industry research, with the 2009 Barclays Equity/Gilt study indicating that, over the 20 years to December 2008, UK equity markets have generated a 4.6% return, while RPI inflation over the same period has averaged only 3.6%. CPI inflation is lower still.
This outperformance over time is due to the fact that company revenues are generated by charging customers. Accordingly, during times of inflation, companies with pricing power can raise their prices and effectively pass on the inflation cost to their customers. In this way, and assuming other costs are kept under control, these businesses are able to maintain, or even grow, their revenues and profitability, despite the inflationary environment.
To this end, blue-chip stocks are very well positioned to withstand inflationary pressure as they offer strong pricing power, dominant market positions, leading brands and strong balance sheets. Sectors that have proven most resilient to the effects of inflation include areas such as tobacco, utilities and pharmaceuticals – stable, defensively-oriented sectors characterised by strong cashflows, leading brands, good pricing power and healthy balance sheets.
Cost discipline is also critical in delivering inflation-beating returns. As such, businesses with relatively low labour costs are at an advantage from the outset, as the impact of wage inflation is often considerably lower than other, more labour intensive businesses. Similarly, businesses offering high value-added products or services are also well positioned during times of inflation, as their bought in costs are relatively small when compared to the selling prices of their end goods.
While the MPC seems confident that inflation will ease over the coming year, and as a result ‘interest rates will remain lower for longer’, there are a number of reasons to suggest stubbornly high inflation may just remain so. The already mentioned liquidity that is yet to flow through to the economy, the impact of a weak sterling, high commodity prices meaning more expensive food and fuel, and the rise in VAT to 20% in January 2011, all look set to play a large part in keeping inflation at uncomfortably high levels. It may just pay to get yourself some protection.
Richard Marwood is senior portfolio manager at AXA Investment Managers
This article first appeared in the 26 July issue of Investment Week
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