Six ways to invest in an inflationary environment

UK inflation rose to 9% in April, its highest level in 40 years and almost double the rate the Bank of England expected six months ago.

Modupe Adegbembo, G7 Economist at AXA Investment Managers, believes this will be the peak. However, she also said that she expects inflation to remain elevated in 2022, before a gradual return to target in 2023. “We now expect inflation to average 7.4% and 3.5% in 2022 and 2023, respectively,” she said.

But what if, as Niall Gallagher, manager of GAM Star Continental European Equity fund suggested, “the past decade was an anomaly and inflation is here to stay?”

Investing in an inflationary environment

Investors have not had to worry about inflation for a generation, so the recent and prolonged spike marks a major change for many.

A small to moderate amount of inflation can be good for investments, but it’s impossible to inflation-proof a portfolio when inflation is as high as it is today. You can mitigate the problem, however.

A combination of dividends and share price could potentially deliver a 7%-9% a year return, for example. But that’s a big ask and by no means guaranteed. As we’ve seen in recent months, share prices can fall as well as rise.

But over the longer term, investing is likely to produce better returns than simply leaving savings languishing in cash. Balance is the key, and much depends on an investor’s age, risk tolerance, and existing portfolio.

Different ways to invest your money

The UK is one of the few stock markets not to have tanked this year and is still relatively attractive on valuation grounds. With its skew towards energy, miners, and financials, it is also well-placed to benefit from the sectors that could perform in this high inflation environment.

Schroder Income and The City of London investment trust are good options here. Not only do you get access to a yield of 4.1% or 4.6% respectively* – which already goes a long way to making up for inflation at 9% – but also to cheaper UK equities and their potential returns.

Inflation protection from Real Estate Investment Trusts

According to Sanlam, REITs have historically provided protection against inflation and outperformed the broader stock market during periods of moderate and high inflation.

“Property values tend to increase as higher prices for labour, materials and land make construction less economically viable without a proportionate rise in rental levels,” said Benette Van Wyk. “This may result in a limit to new property supply, which creates a barrier to entry that in turn results in existing property owners’ ability to increase occupancy levels and corresponding rents.

Hugh Sergeant, manager of ES R&M UK Recovery agrees. “I am becoming really quite interested in Real Estate stocks, starting with the UK but also looking for opportunities elsewhere,” he said.

“They have sold off quite aggressively during the latest bout of big picture worries. This has left stocks such as British Land and Capital & Counties trading at material discounts to NAV despite their strong inflation hedge credentials and their robust recent fundamentals.

“London seems to be back to its vibrant and busy self, with strong footfall and activity, positive for both these property companies which nevertheless have seen their share prices fall significantly. We have been adding.”

Cohen & Steers Global Real Estate Securities and BMO European Real Estate Securities are two Elite Rated options in this space.

Commodities perform strongly

Commodities, meanwhile, have just had one of their best starts to the year in decades. They provided the most reliable inflation hedge during the inflationary period of the 1960s to 1970s, with gold and real estate doing well. And structural forces could keep prices higher than they have been in years.

The manager of BlackRock World Mining Trust spoke about a “multi-decade period of strong demand for commodities in this recent podcast:

Gold has also historically been a great preserver of capital when there is high inflation. It is also seen as a hedge against central bank mistakes – which is a distinct possibility today as they are raising interest rates into a slowing economy. Jupiter Gold & Silver and Ninety One Global Gold are worth a look.

Investing in energy is historically one of the best ways to protect against high inflation too. High energy prices and the war in Ukraine has made renewable energy assets even more valuable. They are benefiting from higher power prices, but subsidy elements are also inflation linked. A double whammy of inflation protection.

VT Gravis Clean Energy Income invests in areas such as solar, wind and hydro-electric power, as well as energy storage, energy efficiency, bioenergy, geothermal, heat pumps and the smart grid, for example.

Bonds still have a place

Bond funds have all suffered losses this year and the 40-year bond bull market could well be over. But this isn’t a time to dump them altogether. They remain an important source of diversification.

Floating-rate debt offers one way to get income today and benefit from rising rates. When you buy a normal bond, you lock in a coupon or interest rate. So, if you buy in a low-rate environment, you will be stuck with that coupon even when interest rates start to rise.

A floating rate note’s coupon, however, is designed to rise (or fall) in line with its reference rate. SVS Church House Texan Absolute Return Strategies has almost 40% of its portfolio in this area*.

Financials are another route. GAM Star Credit Opportunities co-manager Gregoire Mivelaz said: “This is a very challenging environment for fixed income investors in general, but it is actually supportive for our asset class. Financials tend to benefit from this inflationary/ higher interest rates environment and subordinated debt should outperform senior unsecured debt. The asset class can generate a high, steady, quality income from some strong issuers that can perform well in a rising rate environment.”

TwentyFour Corporate Bond also has more than 46% of its portfolio in subordinated financials, including top ten holdings in Virgin Money, NatWest group, Yorkshire Building Society, Direct Line and LV Friendly Society*.

When high inflation is normal

While high inflation is new to many in the UK, that’s not the case elsewhere. “India, of course, has a long history of persistent inflation pressures, driven in part by its greater sensitivity to food price dynamics,” commented Mike Sell, manager of Alquity Indian Subcontinent fund.

“India remains a rapidly growing emerging economy with real GDP growth running at 7-8% pa, underpinned by large working age population growth and strong productivity gains. It is this that enables the economy to tolerate much higher inflation rates, without undermining growth. If the UK is to adapt to higher inflation, it too will need to find a way to raise what for many years have been very anaemic gains in productivity. Otherwise, inflation will simply weigh on UK real incomes and consumer spending power.”

Fighting inflation with increased productivity

Companies can alleviate some of their inflationary problems by making improvements in productivity. Simon Edelsten, co-manager of Mid Wynd International, said recently: “One consequence of higher inflation is greater investment by manufacturers in productivity. In Mid Wynd International we have around 12% of assets invested in automation companies, which are seeing rising orders. These stocks make up a large portion of the trust’s exposure to Japanese equities.

“Japanese exporters are also seeing their competitiveness improved by the falling yen, though many are held back by weak overseas demand, especially from China. With a longer-term view, China will move past the current Covid issues and the government will stimulate the economy, so 2023 could well prove a good year for Japanese exporters.”

Elite rated Japanese equity funds include T. Rowe Price Japanese Equity, AXA Framlington Japan and Comgest Japan Growth.

*Source: fund factsheet, 31 March 2022