Investment: Buying into inflation

Four years on from the collapse of Lehman Brothers, UK inflation remains stubbornly high, growth remains stubbornly weak and the Bank of England remains resolutely committed to supporting growth as best it can. Before inflation is taken into account, growth is 3.1 per cent below the 2008 peak, whereas including inflation it is 7.5 per cent higher.

A series of one-off shocks keeps inflation above target, meaning that real and nominal gross domestic product (GDP) have moved in opposite directions. If this is the case during a period of weak economic activity, whatever the intentions of the Bank, there is a risk of inflation being consistently above-target. How can investors protect their portfolios?

Managing longer-term inflation risk is usually relatively straightforward. There is a well-developed market in inflation-linked government debt designed to protect investors against inflation. The only problem is that, this time around, yields on government bonds are very low and some are negative in real terms. In supporting growth, policy actions of the Bank of England have come at a price: the programme of quantitative easing (QE) has pushed both nominal and real yields down. That does not mean that all is lost however, just that we have to look a little further afield.

While we might not want to buy bonds with negative or close to negative yield, what if we could generate returns just from the future inflation rate? The future inflation rate is the difference between a bond yield that takes inflation into account and one that does not. The difference between the two can be exploited using derivatives. At present, this difference is 2.8 per cent. For investors willing to accept the risks and employ derivative strategies, there are already alternatives, priced at reasonable levels.

For those unable or unwilling to employ derivative strategies, there are other options if we ask ourselves where the major sources of inflation are likely to be. The emerging markets of China, Brazil and Mexico are likely to lead global growth in coming years. These are commodity-intensive economies, and their demand should push commodity prices higher—we will import these commodities at these inflated prices. Investors looking for exposure to inflation via physical assets might consider hard commodities such as oil or gold.

Indeed, in a similar vein, several of these emerging countries also have markets in government bonds that are inflation-linked where yields are still attractive. In Mexico for example, the real yields on such bonds are 1.5 per cent, a full 2.4 per cent higher than our own.

Commodity prices and overseas inflation-linked bond markets are not a perfect substitute for UK inflation; however, they should offer some protection against two of the UK’s bigger risks—imported commodity-based inflation and/or a steady fall in the pound. However, these securities are volatile and should be used as part of a diversified portfolio.

Equities can also play a very useful part, with a focus on companies with good balance sheets, a market leading position and clear pricing power. Reckitt Benckiser and British American Tobacco are two examples in the UK.

In short, it may not be as simple as it used to be, but it is still possible to create a diversified portfolio to address inflation-protection needs. Over time, that should help provide protection against the detrimental effects of unexpected inflation.