James Klempster: Inflation-proofing portfolios

This decade of low inflation has been a boon for central bankers who have been able to follow expansionary monetary policy, almost to an egregious point.

For us as consumers it has also been a welcome treat. Year over year price moves have been pretty sedentary overall, which is certainly preferable to much greater levels of inflation, something that can make planning expenditure far trickier.

Conversely, deflation poses huge risks to consumption as it saps the impulse to spend today because tomorrow's prices may well be a modicum cheaper in nominal terms. For us as investors, low nominal levels of inflation mean that its caustic impact on savings has ceased to be something we are particularly conscious of.

However, this same central bank largesse means that short-term interest rates are so paltry that they are presently unable to keep up with lowly inflation that we have seen in the past decade. As a result, when considering saving or investing for the long-term, inflation beating portfolio returns remains a pivotal concern. 

This is for a number of reasons. Firstly, inflation time series are relentless; inflation is almost always positive, especially in the UK. Consequently, a cumulating inflation time series nearly always goes up in a straight-ish line and it is this compounding of even lowly inflation figures that can be immensely painful in the long run. 

The problem for us all is that it is sometimes difficult to envisage what inflation feels like: its effects are too covert day-to-day to keep us awake at night but recent examples, such as shrinking chocolate bars and the cost of filling up a tank of petrol, make the impact of inflation palpable. 

Taking a longer-term perspective, historical inflation could be a major source of remorse for tomorrow's pensioners. In a world where defined contribution pensions are the norm (meaning investors themselves bear all risks), combined with the risk of increasing human longevity, a lack of awareness of the risks posed by inflation to long-term investors could have a severe impact on pensioners in just two decades.

Therefore it is of the utmost importance that investors make appropriate risk-profiled investments today that are intended to provide returns in excess of inflation over the medium to long-term. 

Volatility

The good news is that, with sufficient time horizons, all assets have historically beaten inflation. It may be difficult to believe but this also includes cash in the UK. Logically this makes sense - why would a rational investor put capital at risk of loss if the returns generated are not even enough to keep up with inflation? 

In this ultra-loose monetary regime, however, cash has not generated a real return meaning that capital left at the back is gradually going backwards once inflation is taken into account.

As we know, some asset classes have high price volatility, whereas others are relatively low. Investing to beat inflation is difficult because of the mismatch in volatility between these different assets and the low volatility nature of inflation. As a result, you shouldn't expect to beat inflation with a month or even a year's returns - it requires a reasonable time horizon.

Volatility may make an investor's journey to their required outcome less palatable, but the reality is that - all else being equal - the best returning assets over the long run often take the choppiest route to get there.  Ultimately this makes sense because beating inflation is done by capturing risk premia and the riskier the asset class, the better the reward should be. 

As a result, over the long term, it is difficult to argue against the equity markets as a powerful inflation hedge. Innately that makes sense. Company management are hired to grow profitability in real terms year over year and successful firms are able to do this which should translate into investor returns. 

Other asset classes that have traditionally been considered to offer inflation protection include commercial property; aided by scarcity premia on premier property helping capital values. More prosaically, upward only rent reviews in the UK may also provide a degree of inflation protection to the income stream. 

‘Liquidity mismatch'

Care must be taken when investing in property to ensure that you are exposed to a decent portfolio of properties and that you do not find yourself at the mercy of a liquidity mismatch between a liquid investment vehicle acting as the conduit for invested capital and a highly illiquid asset underneath. We tend to prefer fixed pools of capital (REITs) where possible.

Inflation-protected gilts should also immunise inflation risk, albeit with lower total returns than property or equity. Gold does not pay income in a way that other asset classes do and so it is difficult to see a direct link between the price of gold and inflation.

However, its currency-like characteristics have tended to provide a store of value against devaluing currencies, which are often a cause for high inflation in the UK. Traditional fixed income securities such as nominal gilts or credit securities are priced as a function of their yield and as a result higher inflation should bode poorly for these asset classes, as higher yields mean lower asset values as prices adjust to provide attractive yields in the market.

Crucially, assets that are expensive when they are bought offer much less inflation protection potential than when they are cheap - simply by dint of their being expensive providing limited upside. As a result, gauging an asset class' ability to beat inflation without looking at prevailing prices will miss half of the picture. 

That is exactly why we spend a lot of time modelling expected real returns for a large number of asset classes over a variety of different economic scenarios. This gives our portfolios the best chance of producing an outcome in excess of inflation. 

As outcomes-based investors we believe the best way to reduce the volatility around stable inflation returns series is to create diversified portfolios that have a genuine suite of differentiated returns drivers contained within them. To enable this, it may be necessary to hold some assets that you do not expect to beat inflation over the medium-term that are instead a decent stabiliser.

There may be times where few asset classes display the necessary expected real return; this is a time for discipline to be applied. It would be all too easy to dominate a portfolio with the few attractively valued asset classes, but doing so is unlikely to provide a suitable balance of risks to investors.

So, while inflation may not be at the forefront of everyone's mind as the key investment risk to protect against, it is relentless and its impact over the long run can be just as damaging as a short-term market correction.

The good news for investors worried about inflation is that there are plenty of ways to beat it if given enough time. In fact, choosing most asset classes most of the time should be enough to get you there eventually.

Though ‘when' and ‘why' returns end up ahead of inflation may be little better than random. Thinking more about the long-term risk premiums available from these different asset classes and critiquing them based on their presently prevailing valuation should help produce more certainty round the outcome. A well-diversified, robust and repeatable process and prudent risk controls should all help to make the journey to the outcome better.

James Klempster is director of investment management at Momentum Global Investment Management (MGIM)

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