Reader Question: Protecting against inflation

During a recent investor event I attended I met a reader of this blog who asked me about protecting against inflation and what options I\’m considering. For those of you old enough to remember such things, there was, once upon a time, a thing called inflation; a rate by which prices would increase every year. This rate was significant enough to be guarded against; in the UK; between 1987 and 1991 it remained stubbornly high at over 4%, hitting a peak of 7.5% in 1991 before falling to just under 2% by 1994. That was the high point for the next six years, but in 2000 it began to climb again, reaching another peak of nearly 4.5% in 2011, before falling back to between 0.5% to 2.5%.

This general trend downwards has been mirrored across most of the developed world; most major economies are struggling to generate any inflation at all, and Japan has faced several periods of increasingly significant deflation since the mid-90s.

This had led most investors my age to view inflationary risks in much the same way as the likelihood of having their horse and cart break a wheel. Neither likely nor relevant. Inflation is simply something old people talk about; it’s a relic of an older economic time and is unlikely to return.

I, however, do not believe that the spectre of inflation has been entirely vanquished. I’ve written here before about Quantitative Easing programmes being undertaken by governments around the world – many of which have been extended and expanded in response to the coronavirus pandemic. Despite economists telling us that a low level of inflation is a good thing, it\’s important to understand what options are available for protecting against inflation, which over time will destroy the value of your money more surtely than any other force I know.

Initial indicators seem to be that the pandemic itself will actually have a broadly deflationary effect on prices. With economic activity sharply in decline, oil and commodity prices have fallen, and retailers have slashed their prices to keep customers buying. As travel picks up again, I suspect many airliners and hoteliers will also discount prices and so I wouldn’t be surprised to see headline levels of inflation turn negative across the UK and Europe over the coming quarters.

As people begin to come back out of their homes and activity picks up again, inflation is likely to return however. The persistent growth in the money supply in the UK, US and EU is likely to drive demand higher and push prices upwards.  Such an outcome would mark a dramatic shift for markets, which have been used to sub-2% inflation for most of the last twenty years. Persistently low interest rates have also forced the price of risk assets higher; pushing savers into investing, investors into speculating, and speculators into all-out gambling in seek of what the perceive to be ‘reasonable’ returns.

Your Portfolio: Protecting against Inflation

If inflation does pick up, regular equities are likely to be a reasonable hedge to protect against it. Companies can raise prices in response to increased costs of production, providing of course that governments don’t begin to ‘cap’ prices in an attempt to hold inflation down. In such a situation, mass bankruptcies are likely as companies costs of production increase dramatically with little ability to compensate for this.

Although traditional bonds are likely to be a terrible position to protect against inflation (due to their fixed rate of return and nominal value), Inflation Linked Bonds (ILBs) are securities which are indexed to inflation – interest rates (and in some cases capital value) rise and fall with inflation meaning that in a rising rate environment they provide strong security.

For example, if you bought a £1000 Gilt paying 1% for ten years, you would receive £1,100 after ten years (your original investment, plus interest of 1% a year). Now let us suppose that you bought an ILB and interest rose from 1% to 3% in year 2, 4% in year 3 and 5% in year 4, remaining at 5% for the remainder of the bond’s life. In this situation you would receive £1,430, with the value of your interest having been increased with inflation.

Year

Inflation Rate

Traditional

Inflation Linked

Starting Value

 £    1,000.00

 £            1,000.00

Year 1

1%

 £         10.00

 £                 10.00

Year 2

3%

 £         10.00

 £                 30.00

Year 3

4%

 £         10.00

 £                 40.00

Year 4

5%

 £         10.00

 £                 50.00

Year 5

5%

 £         10.00

 £                 50.00

Year 6

5%

 £         10.00

 £                 50.00

Year 7

5%

 £         10.00

 £                 50.00

Year 8

5%

 £         10.00

 £                 50.00

Year 9

5%

 £         10.00

 £                 50.00

Year 10

5%

 £         10.00

 £                 50.00

Total Repaid

 £    1,100.00

 £            1,430.00

In theory, this sounds like a wonderful mechanism for protecting against inflation but bear in mind that this calculation must be made relative to other assets in the market. Comparing ILBs with traditional bonds requires an investor to compare the difference between the nominal yield and real yield – the difference being the inflation expectation which has been priced in by the market. If the actual inflation rate over the life of the bond is higher than the rate priced into the bond, an investor would earn a higher return holding ILBs whilst simultaneously reducing their inflation risk.

Traditional bond holders are also unlikely to take the risk of inflation blindly – if markets genuinely begin to expect inflation rates to rise, yields on traditional bonds will begin to climb to reflect this and prices will decline. Current holders beware.

In addition to considering securities such as ILBs, I have also undertaken a review of my portfolio to reduce my exposure to companies trading with significant debts (I mostly prefer debt-free companies, but is companies do use leverage, then I prefer interest cover of at least 2.5x and net gearing of under 40%.

I’ve moved away from highly cyclical companies (sectors such as retail and transport have been easy to avoid) and have moved towards companies with tangible assets such as REITs, precious metal miners, insolvency practitioners and companies with significant track records, large institutional support and controlling family interests.

I’ve reduced my exposure to companies trading at a significant premium to Net Asset Value (anything over 10% makes me a bit nervous). Although this can be a sign of quality, it can also be a sign of irrational exuberance on the part of investors and is mostly to be avoided.

I’m also starting to explore future oriented companies in the pharmaceutical and technology space – in my opinion these are likely to be reasonably performers regardless of the state of the economy. The trick here is to not get sold up the creek ‘buying the dream’ and forget that if a company isn’t profitable then there’s only one thing it can do – raise more equity or take on debt to survive. Such companies often trader at lofty valuations due to the fanciful sales pitches of CEOs and their market teams – but the cash flow statement and balance sheet will soon reveal the truth.

These measures go some way to protecting against inflation but as 2020 draws to a close I\’ll be keeping a close eye on my investments to ensure I\’m well positioned should the spectre of serious price increases return.

Sign up to receive the latest content, fresh from the press.

I don’t spam! Read our disclaimer for more info.