Inflation is part of our economic system. What happens when inflation overheats? In this guide we discuss how we should invest and  allocate assets in times of high inflation.

What is inflation?

Last week I received my heating charge for 2022/23 and it opened my eyes to the looming ‘cost of living’ crisis. Unit cost per kWh is set to go up a whopping 124%. Electricity bill? Another 50%. Other essential items like rail fares, tube tickets, council tax, and grocery have surged too. I reckon that each UK household will spend on averaged at least 50-100% more on critical goods this year.

This is inflation. It means the same amount of money buys less and less goods and services. Clearly, the UK economy is about to be slammed by massive inflation in the near term.

Take a look at the price of wheat. Prices have leaped to record levels since late February as the war in Ukraine escalates.

The $100-a-barrel crude oil is also a big concern. Meanwhile, Copper soared to new cyclical highs. Higher commodity prices will raise basic input costs such as transport, industrial materials and food.

A few weeks back, inflation was caused by three things.  One, the re-opening of the economy. For example, England lifted most of its pandemic restrictions starting on the February 24 as the gov tilts into the strategy ‘Living with COVID’. As a result, travelling increased.

Two, a modest pent-up demand for goods and services boosted commodity prices. There is little or no spare capacity in the market, such as oil as noted by the International Energy Agency recently. Global supply chain is near breaking point due to a lack of cargo ships; while the labour market is tightening. Note, US February employment dropped to 3.9%.

Three, accommodative monetary policies have propelled asset prices upwards. Asset owners have become wealthier during the pandemic and are splashing out, on property and luxury goods.

Taken together, it means prices are rapidly adjusted upwards to reflect this new post-pandemic boom. According to the ONS, UK inflation is now running near 5%, far above the base rate of 0.5%. In the US, things are not much better. Its annual inflation rate soared to a shocking 7.5%.

Inflation will impact every corner of the society and reverberate through the entire supply chain.

Unsurprisingly, household disposable income will plummet. All this will eventually exert upward pressure on wages. A self-reinforcing vicious cycle is now underway – a cycle that is not subsiding any time soon

In these circumstances, what should investors do to navigate through these treacherous macro conditions?

Three Investment Principles During High Inflation

The world is constantly changing. New political landscapes, new technologies, new international conflicts, and new macro environments all fused together to create a new market outlook almost every year. All these new factors will eventually reflect in the financial market, albeit imperfectly.

The decade starting 2020 is going to be much different than the decade 2010-2019. Investors have to understand that whatever happened in the past is unlikely to repeat in the same way. Sectors that outperformed then may become laggards; while underperformers become market leaders.

With this in mind, I highlight three basic principles to invest during a period of high inflation:

  1. Buy equity sectors that can profit from the inflation cycle (pricing power or commodity-related)
  2. Overweight asset classes that benefit from inflation (e.g., commodity)
  3. Hold credit that is inflation-linked

When inflation cycle starts, it will not stop at one or two quarters. Typically, it will last a few quarters or even years.

Once the Fed starts hiking rates, which the chairman hinted it will in March, it will hardly stop at one. You will see several hikes in the coming quarters.

1. Buy energy and commodity-related instruments

Historically, surging commodity prices is the source of higher inflation, with oil being one of the main culprits. Recall that in the seventies and noughties the multi-fold jump in crude prices resulted in surging inflation globally.

While households suffer, oil companies profit from higher oil prices. Many major report significantly higher profits. For example, BP (LSE:BP) rebounded from a $5.7 billion loss in 2020 to a $12.8 billion profit last year – the highest level in decades. The company raked in more than $4 billions in the last quarter of 2021 alone.  Shell (LSE:SHEL) also reported sharping higher net earnings of $19.3 billion.

Miners are too reporting fabulous earnings on rising coal and copper prices. Rio Tinto (LSE:RIO) reported this week net earnings in excess of $20 billion. For BHP (LSE: BHP), its half-year profits was in excess of the $9 billion.

Flushed with cash, these miners and oil majors are enacting massive share buyback programs and returning record payouts to shareholders. Rio’s total dividend for 2021 was $16 billion, the second-largest dividend in FTSE’s history. Should the commodity and energy up cycle extend further, these companies will their reward shareholders further.

In the US, you may take a look at the $33 billion iShare Energy ETF (US:XLE) which holds a variety of energy-related stocks, but primarily Exxon Mobil (US:EOM) and Chevron (US:CVX).

The drawback of buying energy stocks is that this decade may well see ‘Peak Oil’ – due to the gradual phase out of ICE automobiles. Perhaps buying alternative-energy stocks like hydrogen or EV to balance out the risk.

Another point is that junior oils will have a higher beta than majors, so their returns are much higher.

2. Buy selective property/REITs

Properties in good locations are desirable assets. During the last inflation cycle in the seventies, property was perceived as an ‘inflation hedge‘. Some exposure to the property market may help to ride out the inflation cycle. Just recently, Rightmove (LSE:RMV) revealed that the average UK residential property asking price stands at a record £348,804 – the highest level since 2000. Average UK rent is now above £1,000.

Of course, opponents of this ‘buy-property-to-hedge-inflation’ argument will highlight three points.

  • One, the property market is a large one. Capital returns will therefore vary by a great deal. Investors will need to look at the granular level to determine which property sector to buy, and this is difficult.
  • Two, properties need to be maintained and this will erode a significant chunk of capital returns. Tax is another negative point.
  • Three, rising interest rates will incur a drag on property prices (due to higher interest on borrowings).

In sum, investors have to realise that property is not a perfect inflation hedge due to the dispersion of returns in the market.

Due to this reason, investors should hold a few listed Real Estate Investment Trusts (REITs) to gain portfolio diversification. In the UK, two large commercial property REITS are Land Securities (LON:LAND) and British Land (LSE:BLND), while Segro (LSE:SGRO) is the largest warehouse specialist. Within the housebuilder sector, Persimmon (LSE:PSN) and Barratt Development (LSE:BDEV) are two mass-market developers while Berkeley (LSE:BDEV) is the London-centric property developer.

In the US, property instruments to look at include the $45 billion Vanguard Real Estate ETF (US:NVQ) and iShares Real Estate (US:IYR).

3. Buy businesses with pricing power

For many businesses, the point about inflation is that input cost will increase quickly. Material cost, labour cost, and transport cost jump, while their product pricing may not keep up with inflation. This means that real profit margins are compressed.

Businesses that have little or low pricing power will find themselves trapped financially. Investors have to find businesses that can keep pace with inflation, that is, products that have flexible pricing power.

One example is Apple (US:AAPL). The company has a sticky ecosystem that will continue to attract customers despite the rise in costs. Simply, Apple re-prices its product to protect its margins. Google (US:GOOG) is another.

Many luxury retailers can do that because their clientele are far less sensitive to prices, companies like LVMH (US:LVMHF) and Ferrari (US:RACE). Lower-margined retailers, unfortunately, will suffer. For example, look at Asos.com (LSE:ASC). Its share prices have been decimated since last July.

4. TIPS with bonds

Inflation erodes the real purchasing power of cash. Simply, a pound now buys less (and less) goods in the future. Why would investors hold bonds which give out a fixed coupon?

However, not all is lost. These days, you can buy bonds that are linked to inflation. In the UK, they are called Index-linked Gilts. The US version is known as TIPS (Treasury Inflation Protected Securities).

As inflation rises, payouts of these also increase as payments are linked to some inflation measures. This gives investors some ‘real’ protection of the coupon payments.

In the US, the iShares TIPS ETF (TIP) “seeks to track the investment results of an index composed of inflation-protected U.S. Treasury bonds.” The $38-billion ETF holds most of the assets in AAA-rated Treasuries.

In the UK, there is an equivalent bond ETF called the iShares Sterling Index Gilt ETF (INXG, factsheet). Prices have been rising steadily over the past few years (see below)

The drawback of these inflation-linked bonds is that the inflation measure which they are following may not correspond exactly to the inflation. So there could be some discrepancies.

5. Overweight commodities

The last asset that will benefit from inflation is commodities.

One veteran investor, Jim Rogers, has been calling the asset class higher for years. His basic premise is that:

  • commodity prices are not as expensive as stocks, particularly tech stocks.
  • commodity supply has been tightening over the years
  • excessive money printing by the Fed/BoE/ECB/BoJ

A catalyst, such as war, could send the commodity market rocketing. This means that there is upside scope for many commodities, such as Silver, which is still 50% below its 2011 highs.

But bear in mind that commodity prices are hugely volatile. You should not bet all your portfolio on it, only part of it. Prices could drop hard if, say a ceasefire is announced in Ukraine. Therefore buying a basket of commodities is a better option.

Some instruments to look at include Invesco Agriculture Fund (US:DBA, fund site),  Invesco Commodity Fund (US:DBC), iShares GSCI Commodity Fund (GSG) or iShares GSCI Commodity Dynamic Roll (COMT).

Single commodity ETFs include the Gold ETF (GLD) or Silver ETF (SLV).

Study what these funds track because not aIl funds design the portfolio in the same way. Some funds are overweight energy; while some are more evenly distributed among all commodities. I prefer physical-backed ETF rather than synthetically constructed ETF.

To accumulate these funds, wait for prices to cool.

Conclusion

Inflation is becoming a fear factor in 2022. The story this year will be a fall in real spending power and investors have to deal with this new investment landscape accordingly. Gone are the days when stock prices rocket week after week.

The above five themes may help investors to navigate the market better.

But in this increasingly volatile market, cash is a good thing to have, too. Perhaps the mantra this year is not to make the most returns but to lose the least.

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