The UK’s consumer price index (CPI) came in at 2.9 per cent in August – 0.9 per cent above the Bank of England’s target of 2 per cent and well above the 0 per cent figure of two years ago.
Although we don’t think there is much reason to believe this trend will continue (if anything, it should fall back towards the government’s target of 2 per cent), we thought we would look at the impact of rising inflation on investors and how we manage portfolios to mitigate the risk it imposes.
The impact of low interest rates and low inflation
Since March 2009, consumers and businesses have enjoyed the bank base interest rate of 0.5 per cent or less, enabling small businesses to flourish due to the availability of cheap credit and making homeowners feel better off due to the fall in repayments on their mortgages.
But for savers and investors, this low interest rate environment has not been so accommodating, and this has become more pronounced as inflation has increased.
Consumer Prices Index - % change
Source: Office for National Statistics
For those wishing to make decent returns on their savings, they have been forced to look beyond high street accounts – perhaps to government and high quality corporate bonds or equities for those with a higher risk appetite.
This 'hunt for yield' has been well publicised and, as portfolio managers, it’s our job to protect our clients’ wealth from rising inflation at a time when interest rates, and therefore bank account rates, are unlikely to rise dramatically in the near term. So how do we go about it?
The role of bonds
As any textbook will tell you, higher inflation causes bond prices to fall, as investors worry that bond yields will not keep pace with the higher interest rates required to tackle rising inflation.
Despite this, government and corporate bonds play an important role within a diversified portfolio due to their negative correlation to equities, lower volatility and relatively secure income stream.
With higher interest rates anticipated in the future (albeit in the medium-term future), how do we alter our bond exposure to minimise interest rate risk?
Firstly, we reduce the duration of the bonds that we hold. In other words, we reduce the time to maturity of the bond, and therefore reduce its sensitivity to interest rate rises.
Secondly, we hold index-linked bonds as their capital value and coupons are linked to inflation so, in broad terms, as inflation rises, so does the level of income received.
Equities: A natural hedge against inflation
Our portfolios also tend to hold a variety of real assets, such as equities, because they have an intrinsic value due to the company’s tangible assets or intellectual value.
Indeed, equities provide most of the capital growth within a portfolio, while also providing a built-in hedge against inflation. This is because, while companies are initially impacted by the higher price of materials, inflation-driven costs are ultimately passed onto the consumer in the form of higher prices.
We can also be confident that dividend-paying companies will work to maintain or grow their dividends, and companies that reinvest for growth will continue to do so, to maintain investor confidence.
If inflation is expected, and does not rise too rapidly, companies can adapt. A diversified portfolio benefits from having exposure to an asset class which can factor in higher inflation and benefit from it.
When selecting equities, either directly or via collectives, we ensure that we invest our clients' money in high quality companies which have experienced inflationary periods, and have proven that they can manage these conditions.
Inflation outlook
Inflation, which rises rapidly, will tend to take both businesses and consumers by surprise.
However, our expectation is for a moderation of inflation towards the Bank of England's target rate of 2 per cent. In this environment, a well-diversified portfolio remains one of the best ways to protect wealth against rising prices, and we will continue to run our clients' portfolios accordingly.
Cynthia Bowring is portfolio manager at Sanlam UK. The views expressed above are her own and should not be taken as investment advice.