A guide on how investors can protect against inflation

We share inflation-proofing ideas for equities, funds and trusts for investors looking to add protection to their portfolios.   

After a decade largely out of the limelight, inflation is back on investors’ radars. UK consumer prices index (CPI) inflation leapt from 1.5% in April to 2.1% in May – above expectations, and the Bank of England’s target 2% rate.

It’s hardly surprising that prices are rising, given the financial pressures on businesses as they attempt to open up after more than a year of disruption. As Rob Burgeman, senior investment manager at Brewin Dolphin, explains: “Restaurants, for example, are likely to open with reduced capacity, with a huge demand and with debts that need repaying. So prices are almost certain to rise.”

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This is likely to be relatively transitory, as the economy feels its way back towards something like normality. However, for Darius McDermott, managing director of fund research firm FundCalibre, the US Federal Reserve’s recent move to increase inflation expectations for this year and bring forward its time frame for interest rate hikes to 2023 is noteworthy.

“We feel inflation could be slightly more embedded in markets than we thought it was earlier in the year,” McDermott comments.

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An element of inflation can work to investors’ advantage, but the key difficulty is that rising prices erode the purchasing power of your money. So where can you invest to protect against such erosion?

“Ideally, what you need in an inflationary environment are either assets with built-in inflationary protection - index-linked bonds, some property, many infrastructure contracts and the like - or equities; but specifically stocks that have pricing power and can therefore pass cost inflation on to their customers without this impacting revenue,” explains James Carthew, head of investment companies at QuotedData.

Let’s look at the various options.

Equities

As Rupert Thompson, chief investment officer at wealth manager Kingswood, observes: “Equities generally should provide some protection against a moderate rise in inflation, as a result of companies’ ability to pass on cost pressures” by raising prices. But he warns that equities are less effective as a hedge when inflation rises above 3% or so, as valuations tend to be impacted.

Moreover, not all companies are equally well placed to pass on rising costs. Basically, those with the strongest competitive advantage are likely to prosper, says Abdulaziz Alnaim, portfolio manager at Mayar Capital. “Those businesses with wide and robust ‘economic moats’ should be able to use that advantage (brand, scale, and so on) to mitigate the impact of inflation over time.”

Nor are all types of equity similarly attractive in such an environment. Growth stocks tend to be more dependent on borrowing, which could get more expensive if interest rates are raised to combat inflation. They also trade on the prospect of future profits rather than current cash flow, so they tend to suffer more than well-established dividend-paying or value stocks when prices are rising and the real worth of future profits is at risk.

“In an inflationary environment, it is good to invest in real companies making real things that are making real profits and producing real dividends,” says Burgeman.

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Among the best sectors to provide inflation protection, Burgeman picks out supermarkets, such as Tesco (LSE:TSCO), which are able to pass on higher prices immediately; consumer staples companies, such as Unilever (LSE:ULVR), where again consumers will accept price rises; and banks, such as Barclays (LSE:BARC), which benefit from the prospect of higher interest rates.

Many businesses in these sectors have the added advantage of paying investors reliable and growing dividends. McDermott suggests accessing them through income-focused funds such as Man GLG Income and Rathbone Income, which invest in high-quality companies.

McDermott also highlights the strengths of funds with a smaller-cap bias, as the more robust smaller businesses may have additional pricing power “Small-caps managers are some of the most talented stock-pickers, so a global fund such as Baillie Gifford Global Discovery could also be of interest.”

In the investment trust space, Burgeman picks out the “very well-run” BlackRock Throgmorton (LSE:THRG) investment trust for exposure to UK mid-cap and smaller companies. The Diverse Income Trust (LSE:DIVI), managed by Gervais Williams and one of interactive investor’s Super 60 picks, also invests in this part of the market.

Bonds

Inflation is well-recognised as the enemy of fixed-interest investors, as it erodes the value of their income. However, here, too, it’s the case that some types of bond are much more resilient than others in the face of rising prices.

One consideration is duration. Short-duration bond funds, investing in bonds close to maturity, offer less exposure to the risk of higher interest rates.

James Burns, who leads the multi-manager team at Smith & Williamson Investment Management, says: “We’re very underweight conventional bonds at the moment, but where we do have exposure, we protect ourselves as far as possible by being short duration, through funds such as AXA US Short Duration High Yield and Liontrust Monthly Income Bond.” 

Index-linked bond funds, which pay a coupon linked to the level of inflation, are also used by Burns. He favours the AXA Sterling Index Linked and the ASI Global Inflation-Linked Bond funds. “We are not expecting inflation to roar ahead but there does not need to be a huge uptick in prices for these to be beneficial to the portfolio,” he comments.

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It’s also possible to find index-linked bond exposure within broader multi-asset funds. For example, within the flexible investment trust sector, Carthew points out that “trusts such as Personal Assets (LSE:PNL), Capital Gearing (LSE:CGT) and Ruffer (LSE:RICA) have meaningful exposure to index-linked bonds”.

However, Thompson sounds two notes of caution in regard to inflation-linked bonds. First, they are very expensive because pension funds are so keen to hold them, with a current real yield of -2.5% on UK index-linked bonds. That means they do not provide complete inflation protection as they will return 2.5% less than the inflation rate if held to maturity.

Second, they tend to be long-maturity holdings, exposed to any rise in real yields, and therefore can be quite volatile. “UK index-linked bonds, for instance, have lost 3.2% in value this year, even though inflation worries have been on the rise,” Thompson adds. He therefore favours US inflation-linked bonds, which have a real yield of -0.8%, via the hedged version of the Lyxor Core US TIPS ETF (LSE:TIPG).

High-yield bonds are another option for fixed-income investors. As Colin Finlayson, co-manager of the Aegon Strategic Bond fund, explains, they are much less closely tied to changes in government bond yields than are higher-grade bonds. 

Further, because they are commonplace in more cyclical parts of the market that benefit from increasing economic activity, they often enjoy a rise in value during such times. “A rise in inflation can also help bonds issued by those companies with high financial leverage, as this will reduce the real value of their outstanding debt and interest bills,” Finlayson adds.

Alternatives

Investing in infrastructure, real estate and other ‘real assets’ can be an effective way to shield against inflation. Phil Waller, manager of the JPMorgan Global Core Real Assets (LSE:JARA) trust, explains: “Real assets have inherent protections against inflation through the income they generate. For example, real estate assets generate income from property leases, and infrastructure investments from long-term contracts. Inflation linkages are often written into these contracts.”

Capital growth of real assets can also be boosted by inflation alongside capital growth, he adds, because demand for them tends to rise when economies are thriving. “That can translate into higher capital values and higher rents.”

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Among property trusts, Carthew makes the point that although many property rental contracts have upward-only rent reviews that will tend to keep at least partial pace with inflation, a few have an explicit inflation linkage. For example, “Civitas Social Housing (LSE:CSH)’s contracts are indexed to the consumer prices index measure of inflation,” he says. 

Illiquid assets such as property should be directly held via a closed-ended investment trust where there’s no risk of holdings having to be sold to provide cash for a run on the fund.

Gold, another real asset, is a traditional choice for investors in inflationary times, though it can be volatile. Nonetheless, says Thompson, “we hold it both as a source of protection both against a sizeable risk-off move and inflation”. He uses the iShares Physical Gold ETC (LSE:IGLN), which is one of interactive investor’s Super 60 picks.  McDermott prefers the actively managed Jupiter Gold & Silver or Ninety One Global Gold fund.