What to invest in when inflation is on the rise
The pound fell 2% against the dollar and the euro immediately after the UK election exit poll correctly predicted that the Conservative government would fail to secure enough seats to form a majority government. A weaker currency generally leads to higher inflation as the cost of importing goods and services increases. We look at which investments tend to rise in line with prices and how you can protect your portfolio against inflationary pressures.
The two main measures of inflation in the UK are the Consumer Prices Index (CPI) and the Retail Prices Index (RPI). Both track the changing cost of a fixed basket of goods. Both measures have risen sharply since the EU referendum, with RPI rising to 3.8% in April, up from 1.7% in June last year.
Inflation can be caused by the economy growing too quickly because firms push up their prices as they approach full capacity. This is called ‘demand-pull’ inflation. As economic growth is not above the long-run rate of growth, the upwards trend in prices shown in Chart 1 is unlikely to be a product of this type of inflation.
On the other hand, a rise in prices can be caused by multiple supply-side factors. This is when the price of inputs such as wages and raw materials, or the cost of imported goods and services, start to increase. This is called ‘cost-push’ inflation and this has been the main culprit of inflationary pressure over the last year.
Narrowing this further, wage growth in the UK remains subdued while Bloomberg’s Commodity Index shows that commodity prices have tumbled year-to-date. This leaves the rise in the price of imported goods and services as an explanation for the uptick in UK inflation since the UK’s referendum on the EU membership resulted in a vote for the so-called Brexit. The reason for this increase is the depreciation of the pound.
Chart 2 shows this inverse relationship. As sterling depreciates against other major currencies, imports become more expensive.
After the result of the EU Referendum, sterling plunged 9% against the dollar and 6% against the euro. Fast forward a year and Prime Minister Theresa May decided to call a snap election in hope of securing a landslide victory that would strengthen her hand for the Brexit negotiations. Instead, the Conservatives fell short of the 326-winning post, leaving the party with the need to form a minority government propped up by the Democratic Unionist Party (DUP) on a vote-by-vote basis.
Unsurprisingly, this fresh bout of political uncertainty caused the pound to lose further value against the euro, and it hit the lowest level against the euro since 2013 after discounting the freak ‘flash crash’ event of October 2016.
A further weakening of the pound will intensify inflationary pressures which will prompt some investors to look to certain investments that have the potential to rise in value at a higher rate than the headline inflation figure.
Inflation is commonly argued to be a bond's worst enemy. This is because rising inflation often forces interest rate setters to increase short-term rates in an attempt to cool the demand for borrowing, which will help prevent the economy from overheating.
As interest rates increase, newly issued bonds may carry higher rates of interest which would consequently reduce the value of bonds that are already in issue and carry a lower yield. This is why bond prices and interest rates have an inverse relationship.
Investors can mitigate this risk by holding bonds that have a shorter duration (bonds that are closer to maturity) or by investing in index-linked bonds if they believe inflation is about to increase.
IG Smart Portfolios currently contain iShares Ultrashort Bond ETF (ERNS) and iShares Index-Linked Gilts ETF (INXG) to combat rising inflation expectations.
Theory suggests that if prices rise across the economy, the share prices of companies should increase proportionally as firms are able to maintain real cash flows by passing higher costs onto consumers.
Over the past 100 years, UK equities have averaged a 5.0% real return.1 A real return shows the annual rate at which an asset grows in value above the rate of inflation. This implies that over the long-run, UK equities have been a successful inflation hedge. The story is the same for US stocks which have provided a positive real return for every 20-year period since 1900.
In practice though, this may be a far more arduous and sensitive process for some firms in particular industries.
When singling out individual companies or sectors that have the potential to perform well in a rising inflationary environment, it is key to identify businesses that have the ability to pass on rising costs to consumers or other firms down the value chain. The energy and mining sectors are good examples of these and have historically had a strong relationship with inflation.
Investing in sector exchange traded funds (ETFs) is a popular way of gaining exposure to a large number of energy companies. SPDR MSCI World Energy UCITS ETF (WNRG) tracks the price of 90 oil and gas companies for an annual charge of 0.30%.
Financial stocks can also outperform in an environment where inflation is on the rise. Higher rates of inflation imply higher interest rates and this would be good news for UK banks after a period of record low borrowing rates since 2008 left profitability depressed.
The near-zero interest rate environment has meant that the difference between the income, which financial institutions generate from lending out money, and the interest they pay on deposits has been squeezed. Net interest margins at banks should therefore benefit from higher interest rates.
X-trackers MSCI World Financials Index ETF (XDWF) is designed to track the global financial services sector. This ETF charges just 0.10% to track the likes of JPMorgan Chase, Goldman Sachs and American Express.
You can use our ETF Screener to identify other sector ETFs that you may be interested in.
1 Barclays Capital Equity Gilt Study 2016