How to protect against inflation

It is a question that has regularly landed in my inbox this year: I am worried about inflation. How do I protect my investment portfolio?

Let me start with the observation that, on my assessment, still less than half of all investment experts are predicting a fundamental change in the outlook for inflation. And many of those expert voices have an agenda, a built-in bias or a history of proclaiming the end is nigh or the system is approaching its ultimate day of reckoning.

For example, think of the always-buy-gold bugs (alongside silver). Today's true believers in crypto. Your old-fashioned, true blue cheap-value-is-everything investor, many of whom also believe risk assets are in a bubble and the Fed's QE policy alone is responsible for the outperformance of growth stocks pre-November last year.

Having said so, it cannot be denied many more expert voices and market participants are paying attention this year, if only because most portfolios and strategies were not prepared for potentially higher inflation. In addition, one can never be 100% certain about these matters - so it's best to hedge and to re-align so that one unforeseen event doesn't destroy all the good work done previously.

As one prescient expert put it recently: inflation might prove transitory, but a lot of damage can be done in the meantime.

Judging from the emails and messages I have received since the beginning of the year, I am certain many investors agree with that assessment. Share prices for some of last year's share market champions are down by 50% or more. This whole market reset has been nothing but brutal for particular pockets and corners, impacting portfolios, returns and strategies.

Ironically, I've also observed a new stream of expert voices seems to be rising to the surface; one that is looking beyond the current supply-chain bottlenecks and production shortages, questioning the sustainability and the severity of this year's economic recovery. What if next year brings disinflation, if not deflation, rather than run-away inflation?

Needless to say, this year's Grand Debate among experts and investors worldwide is to remain inconclusive for a while longer. My take on it from two weeks ago: 

Inflation is the 2021 'Grand Debate'

Irrespective of one's own views, bias or portfolio positioning, it does make sense to re-align portfolios and strategies, even after the adjustments that have occurred already since November last year. Because if inflation does decide to stick around for much longer, global re-positioning in financial assets will have a lot longer and farther to run still.

Basic rules of inflation

Let's not make this subject too complicated. Higher inflation weighs on asset valuations, which is why investors have been selling equities trading on high PE multiples (in a general sense) and buying into laggards and lower-priced equities instead. This has been factor number one underpinning the switch from Growth and Quality into Value and Cyclicals.

Another factor is that if higher inflation translates into higher bond yields, in particular at the longer end (further out) then most financials stand to benefit.

Hence why Australian banks have made such a forceful comeback. However, all else remaining equal, this should equally have benefited insurance companies and other financials, but we only have to look briefly at share prices for the likes of Challenger (ASX: CGF) and Insurance Australia Group (ASX: IAG) to find out that other factors still have a say as well.

Inflation and bond yields are one factor, but they are not the only drivers for share prices.

Inflation also favours real assets above financial assets. Think bricks and mortar properties, but also so-called "hard" assets like oil, gold, metals, and even agricultural products, not just timber and wood chips.

Again, since January the share price of Woodside Petroleum (ASX: WPL) has gone from $27-plus to below $22 today. Santos' (ASX: STO) share price shows a much flatter trajectory, while Senex Energy (ASX: SXY) has simply continued trending upwards.

A highly simplified way of looking at inflation is that most industrial companies buy in commodities and other input materials, meaning their margins are coming under pressure unless they have strong pricing power.

In a simplified set-up, this pits the likes of Amcor (ASX: AMC), Ansell (ASX: ANN) and Incitec Pivot (ASX: IPL) against the producers of basic materials, such as BlueScope Steel (ASX: BSL), Oil Search (ASX: OSH) and BHP Group (ASX: BHP). Yet again, if inflation really takes off, those producers will start feeling the squeeze themselves from rising inputs and slowing demand.

As an investor, one should always be careful what to wish for. We might just get it in spades, and not fully realising the potential consequences. Today's doom and gloom scenarios, or at least one of them, involve persistently higher inflation which forces central banks to turn less accommodative, with a devastating impact on assets, economies and government finances.

Inflation and bond yields are one factor, but seldom the sole defining driver. This is why formulating an answer to what appears a simple and straightforward question is more complicated than one might think, especially now that bond yields have calmed down and a large re-adjustment between opposing parts of the share market has already occurred.

The case for real assets

Wilsons last week explained the case for increased exposure to real assets during times of inflation outbreak uncertainty. Such hard assets tend to preserve real value in an inflationary environment, in addition to truly acting as a portfolio diversifier and often offering lower correlation with equities and bond markets.

Wilsons also suggests hard assets reduce portfolio volatility, but that would be the topic of fierce debate. Just like gold doesn't always retain its momentum in the face of inflation, and iron ore prices will sink if China stops buying, regardless.

Wilsons also advocates investors looking to diversify because of inflation concerns should broaden their spectrum and include real estate and infrastructure. Most infrastructure assets have an explicit link to inflation through regulation, concession agreements or customer contracts, explain the analysts. This means they can increase prices at least in line with inflation, and without impacting on demand.

Gold has a history of generating strong returns during times of high run-away inflation, while Wilsons also includes exposure to farmland.

UBS's and JPMorgan's global macro strategies

Making matters a little more complicated, there is a difference between nominal bond yields moving higher and the direction in real bond yields -adjusted for inflation- global strategists at UBS once again explained last week. Nominal bond yields did surge earlier in the year, but real, inflation-adjusted yields are still near an all-time low in the US.

UBS predicts real bond yields will start trending upwards later in 2021. This eventually turns into a negative as rising real yields slow down economic activity. However, this should not become an issue anytime soon, and central banks are keeping an eye out as well (insofar they can retain control).

Assuming UBS's scenario plays out, Value stocks should outperform, as well as US small cap stocks vis a vis the large and Megacaps.

Strategists at JP Morgan have started advocating for a more nuanced approach in the Value versus Growth debate. In their view, certain segments in the Value basket no longer automatically represent opportunity, while the trend among Growth stocks is turning favourably towards GARP - Growth at a Reasonable Valuation.

Maybe JP Morgan's assessment is the most valuable among all now that market momentum has turned, and that initial, large re-adjustment between Winners and Laggards has taken place.

Find those companies that are able to grow profits and create shareholder value next year and in subsequent periods. Don't own them at too high a valuation.

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