The rising tide of inflation: Investment ideas to protect your portfolio

Will Railton
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Inflation is a real bogeyman for investors, and it rankles most when you don’t see it coming. Few predicted the oil price rebound at the end of last year – a big influence on prices – or the optimism which caused yields to rise after Donald Trump’s election.

The threat that rising prices will erode wealth is a particular concern to UK investors. Sterling has fallen by 15 per cent since the referendum against the dollar, pushing up import costs for businesses and consumers, alongside other pressures such as costlier plastics and steel. The Bank of England expects CPI inflation to reach two per cent this quarter, peak at 2.8 per cent in the first half of next year, and fall back to 2.4 per cent in three years’ time. The rate-setting committee could yet decide to intervene and raise interest rates to stop prices overshooting its two per cent target, but it is unlikely to do so unless wage growth picks up and consumer spending remains robust.

And with the yield on two-year gilts much lower, at just 1.25 per cent, Brits can’t afford to sit back and do nothing. So here are some ideas for protecting your portfolio from rising prices.

Hedge your bets

There are two useful guidelines when it comes to picking assets which will resist inflation, according to Michelle McGrade, chief investment officer at TD Direct Investing. The first is to make sure you choose genuine hedges against inflation. The second is to plump for ones which are uncorrelated to the performance of other asset classes, so their performance won’t dip if the rest of the market does.

Read more: Investing in infrastructure: Are pipes and roads the new bricks and mortar?

Index-linked bond funds can provide a source of immunity, and the Pimco Global Real Return fund offers exposure to diverse credit of intermediate duration, as do infrastructure funds. Not only are the returns from projects such as toll roads linked to inflation, but the US and UK governments are increasing their investment in public projects – Trump has talked about a binge worth $1 trillion (£800bn).

McGrade recommends the Artemis UK Select fund and First State Global Listed Infrastructure, which invests in the shares of firms involved in building highways, railways and ports as well as utility companies, rather than the infrastructure assets themselves. It’s up 33 per cent on last year.

Prize pricing power

Cyclical stocks tend to perform better in reflationary environments, particularly companies which are able to set their own prices. Look for those with a durable advantage over their competitors, banks and other reliable dividend payers, or equity income funds for a reliable return.

One good option may be the Miton UK Multi Cap Income fund, which topped Sanlam Private Wealth’s recent equity income study. Holding a range of different sized companies allows managers Gervais Williams and Martin Turner to overcome liquidity obstacles, and they meet regularly with firms’ senior management teams to assess whether capital expenditure can really improve their productivity.

Read more: The year of the stock picker: Which UK shares look a bargain in 2017?

European equities

Equity markets have seen huge inflows in recent months, thanks to a belief in Donald Trump’s reflationary policies. But US equities now look overbought and the stronger dollar means they are particularly expensive for UK investors.

Flow data indicates that American investors turn to European stocks whenever expectations of inflation rise

European shares – unloved of late – look a bargain. BlackRock has recently moved from neutral to overweight on European equities; global chief investment strategist Richard Turnill described them as “big beneficiaries of the broadening global reflationary environment, and [we] believe investors are too sceptical of the region’s prospects.”

There are a number of reasons to like European stocks. First, the euro is very undervalued, so stocks denominated in the single currency look cheap, even for sterling investors. The OECD’s measure of purchasing power parity puts the euro lower relative to its fair value than any of its G10 peers, including the pound.

Second, fears that European elections this year could cause the Eurozone to disintegrate are overblown. The greatest risk comes from France, where the economically liberal Francois Fillon now trails Marine Le Pen in the polls, emboldening her to wax lyrical about Frexit and her plan to redenominate national debt in francs. The spread between 10-year French bonds and safer German bonds has reached its widest in four years, showing that investors are getting nervous.

But staying sanguine will probably pay off. “Contrary to an opinion that is very widespread internationally, the probability of a shock vote looks low in both France and Germany,” writes Jean-Charles Meriaux, chief investment officer of DNCA Investments. And even if Le Pen does win, Frexit has little support among lawmakers from other parties or the wider French public. That probably won’t stop a sell-off after polling day though, and the chance to pick up a bargain.

Better still, Europe tends to do well in times of reflation. Flow data indicates that American investors turn to the continent whenever expectations of inflation rise, according to Heartwood Investment Management’s Jaisal Pastakia. “European companies derive 50 per cent of their sales outside of Europe,” he writes. “Second, and more crucially, these companies tend to have a higher fixed-cost base and are therefore more sensitive to changes in sales, meaning that they should benefit more on the upside as sales pick up.”

Do not be in cash

The most important thing to remember is that higher inflation will eat into the value of any money you have sitting in cash because returns tend to be lower than the rate of price rises.

Read more: Inflation is striking back – and it will have implications for our politics

Figures by Fidelity show that if you had kept £15,000 in the average UK savings account for the ten years to 31 December 2016, you would have made a return of just £846, compared with the £10,769 you would have made by investing the same sum in the FTSE All Share index over the same period.

“That’s a difference of nearly £10,000 – too big for any sensible saver to ignore,” says Fidelity's investment director Tom Stevenson.

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