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UK inflation has been rising in 2021. It more than doubled in April to 1.5% as clothing, footwear and energy prices rose. Inflation erodes the “real returns” of investments – e.g. if an equity fund rises 4% in value over a 12-month period but inflation also rises 2%, the “real value” of your returns is 2%. As such, many investors are concerned about what this could mean for their investment strategy. Unfortunately, there is no cast-iron method to predict whether inflation will rise significantly within a given timeframe – or by how much.
Investors should, therefore, be wary of re–balancing their portfolio to anticipate an event that may never transpire (e.g. inflation over 5% over the next 3+ years). Those who are concerned about inflation, however, might want to consider how the strategies below may apply to their portfolio – in discussion with your financial adviser or planner.
When an investor is concerned about inflation, he/she may wish to look for assets which protect against inflation – or which may actually turn a profit in a high-inflation environment. One method is to consider inflation-linked bonds (or “linkers”). Here, the income payments from the bonds – and their capital value – rise with inflation, as defined by the Retail Price Index (RPI).
These investments might seem like a no-brainer to many investors. Yet they do come with their own risks. In particular, most linkers have long lives (e.g. 5 or 10+ years before the government pays you back), during which time interest rates could move significantly. If you buy a bond in a low-interest rate environment and rates are higher at a point where you want to sell it, then it will have lower market value to other investors (who can find bonds offering higher interest rates – i.e. profits – elsewhere). Currently in 2021, the UK’s base rate is very low – at 0.10%, which does not leave much room for them to go lower! Therefore, if you’re attracted to linkers, you may wish to ensure you can commit to the full maturity of the bond.
Equity & inflation
High inflation (e.g. above 5%) is usually bad news for companies and their valuations. This is because their input costs – e.g. raw materials for products – go up, and these cannot be easily passed down to customers (resulting in squashed profits). However, whilst equity is volatile in any equity environment, it’s important to note that different equity sectors can perform differently when inflation is high. For instance, utilities, financials and consumer staples often produce a higher medium return under such conditions. Others such as energy, technology and consumer discretionary are often negatively impacted. There are many reasons for this. A crucial one is that the likes of consumer staples are things that people have to buy even if prices rise. Others which encompass more luxury items (e.g. tablets and smartphones) often see lower demand when everything gets more expensive.
This can lead investors to consider rebalancing their equity portfolio towards the former sectors if they expect inflation to experience a big rise over a long period. Another strategy might be to consider thematic equity funds, which seek to pool investors’ money into stocks which fund managers expect to weather – or benefit from – higher inflation.
Whether or not we do all witness a period of protracted, high inflation in the UK is yet to be seen – of course. Yet, at the time of writing, there is insufficient evidence to suggest this will happen. A lot of the price movements we are seeing at the moment are linked to short-term movements, in particular the higher price of oil as national economies re-open after protracted COVID-19 lockdowns. Consider working with a financial planner who can help keep your ear to the ground.
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