Inflation Conscious Investing: Kindling in Search of a Match?

This article is sponsored by Aria Capital Management 

Given the extraordinary central bank involvement in financial markets in recent years, namely the grand financial experiment referred to as ‘quantitative easing’, investors increasingly are faced with the prospect of rising inflationary conditions. On balance, prices and interest rates have fallen for decades, and the vast majority of investors are not positioned for, or do not hold, investments which will resist or even benefit from a sustained rise in inflationary pressures again.

There are individual investments which are recognised as being ‘inflation-linked’, such as gold mining shares for example, but unfortunately, being exposed to a single asset class brings with it unwelcome volatility associated with a single theme, and therefore the potential for major market reversals and the for performance which is highly correlated to traditional investments, to which investors are most likely already invested.

Therefore, as a consequence of an extended period of muted inflationary pressures, most investors are significantly underexposed to inflation-linked investments.

This article seeks to set out a plan which can provide for a forwards looking portfolio, with inflation protection built in.

E M A I L E D C O N F I R M A T I O N

Inflation Introduced and the Rising Risk Factors

Hypothetically speaking, let’s re-wind the clock. Let’s choose a period from which until now, historically, inflation has been at its most subdued. So rather than investing monies with a return, an investor chooses to put his hard earned lucre under the mattress, doing so in 1982. Roll forward 30 years, and those monies, in terms of what can be bought with them, are worth approximately 57% less. The culprit-in-chief? Inflation. Let’s consider inflation from another perspective, one readily understood. How much was your house worth 20 years ago? And now? In many areas in the world, homeowners who were able to buy their homes 20 or 30 years ago, by today’s prices, would not have been able to reach as their salaries have not kept pace with house price inflation. As inflation rises, the value of your money falls.

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Over time though, history has not always seen such periods of contained inflation pressures. For examples, we can look at historical data from the UK over the past 50 years (chart below). It is often extraordinary economic events which can drive inflation higher. For example, the oil crisis of the 1970’s pushed inflation or the ‘pace of annual price increases’ to more than 10% per year during that episode. It’s easy to forget in our daily lives, the extraordinary circumstances we find ourselves in, but where in developed countries in Europe, interest rates at banks are often negative, it’s certain we do live in exceptional times.

Inflation is muted compared to historical averages

Chart 1
RPI = retail price index a measure of inflation given the change in prices of a basket of goods

Given the mountainous levels of quantitative easing, and the money printing that this translates too, there is significant potential for much higher inflation in the coming years. As inflation resets to even what would be considered historically usual levels, interest rates have begun to follow.

Some of the world’s central banks have now begun to reverse the quantitative easing programs of recent years, but globally the US Federal Reserve, the UK’s Bank of England and their European and Japanese counterparts still have hugely bloated balance sheets, a reflection of the amount of monetary stimulus and excess monetary reserves they have created in the system. This is the kindling in search of a match we refer too – the fuel of a potential inflationary fire. After the third round of quantitative easing in the US, a further $4 trillion was added to the Federal Reserve’s balance sheet while pushing excess reserves to almost $2 trillion.

Whilst central banks will always remain ‘vigilant’ with regard to rising inflationary pressures, and would at least indicate a willingness to raise interest rates to quell them, in some regards their hands may be tied.

Given the economic distress caused by the global financial crisis of 2008, is seared into the minds of all investors, central banks will be wary of raising interest rates to quickly and causing another downturn given that the recovery has been weak generally. The tendency will likely be to remain ‘behind the inflation curve’ and keep interest rates low so as to provide support for an ongoing recovery. The risk that presents of course, is that once the inflation genie is out of the bottle, it is difficult to put it back in again!

To play the devil’s advocate for a moment, central banks may even have other cause to stay their hand and allow inflation to rise towards and above their longer term historical targets…..As we have already seen, inflation reduces the real value of your cash, whether that be in a bank account or under the mattress. It has the same effects on debts, reducing their real value.

The world is still weighed down by significant debt globally, particularly by historical standards. That debt burden needs to be paid down, in order that it not hinder economic growth. A little inflation can help in reducing the outstanding value of that debt and hence policy makers may have an incentive to allow pricing pressures to pick up a little beyond their publicly stated target levels.

A dramatic increase in central banks balance sheets has created massive excess monetary reserves in the system 

Chart 2

Whether you have a mortgage, or you’re an institutional investor running a behemoth public pension that has to provide ongoing member payments, we all have future liabilities which are impacted by inflation. Whilst the inflationary environment remains placid as we stand, complacency sets in easily and investors perhaps ignore the need the protect against the perils of inflation.

However, even a modest pick up in inflationary pressures can have a significant effect on the real value of investor’s portfolios, and it seems prudent, whilst most inflation protection strategies or assets are attractively valued, to begin to build exposure now. Put another way, Noah built the ark before the rains…..(perhaps because timber was attractively priced!). Inflation protection should be part of the consideration in building any longer term investment strategy.

Identifiying Inflation-Protection Investments 

If it was possible to design the perfect inflation protected investment, it would offer the following characteristics:

  • Provide a hedge against anticipated and unanticipated inflation
  • Produce a positive real return (returns greater than prevailing inflation)
  • Minimal volatility, and capital preservation capability

Do you have any tips?

In broad brush terms, inflation sensitive assets revolve around three distinct investment categories 1) explicit inflation linked securities – like UK index linked Gilts (government bonds), or their US equivalents, Treasury Inflation Protected Securities – TIPS; 2) commodity based strategies and finally 3) income-generating assets that are often asset backed and whose income streams can rise with inflation. Examples include real estate investment trusts, (REITs), natural resource investments and infrastructure related assets. It’s unlikely any given investment will bring all three qualities identified above, but in combination, a portfolio of them is much better placed to bring all three characteristics to bear.

  1. Inflation linked Government Bonds:

Issued by governments such as the US and the UK, the difference between these variants and everyday nominal government bonds, like UK Gilts, is that their value is adjusted based on inflation – it will be linked to a pre-defined widely recognised inflation measure, typically a consumer price index of sorts (CPI). Whilst their values offer an explicit link to inflation, there are still, just like normal government bonds, subject to interest rate risk. Many are longer term in maturity and that means having to hold until they do mature in order to guarantee the capital value.

2. Commodities:

Whilst not offering an explicit link to a given inflation index like TIPS or Index Linked Gilts do, commodities are renowned as offering protection against inflation – or holding their value in times of rising inflation. Commodities such as oil, industrial metals, precious metals and agricultural commodities have historically kept pace with rising prices. That’s intuitive to the extent that is was the rise in oil prices that drove prices higher in the oil crisis episode of the 1970’s. A shortage of raw materials, means an increase in the input costs of many goods, hence meaning that the prices of those goods increases, which is ultimately reflected in CPI indices. Secondly, precious metals or gold, less likely to be an input into a consumer good, (other than jewellery), has also demonstrated benefits in inflationary periods. However, gold is less likely to ‘shine’ during periods of modest inflationary pick up, rather during times of more extreme financial market disorder. For example, as interest rates rise in the US, many emerging market currencies are falling against the US Dollar, which imports inflationary pressures into those countries, (as many commodities are priced in US Dollars). For emerging market investors then, holding gold preserves the value of their investment, against rising inflation and falling currency prices.

3. Income generating Real Assets

This being the widest category, there are number of different investments which offer an income, backed by a tangible asset, and the potential for both to increase in real terms over time. Global property, (like Real Estate Investment Trusts), natural resources, and infrastructure all would fall into this category.

Many investors are familiar with the REIT concept, whereby a portfolio of office, industrial, retail, residential or even these days, ‘data centres’, can generate a rental income stream that is distributed by way of dividend, by the REIT to investors. The tenants are typically contractually obliged within their leases to pay rental that increases over time. (There may even be a contractual tie to a particular price index). Of course, the value of the property portfolio over time may also increase. Investors though, need to be mindful of REITs which are highly geared – i.e. they have borrowed extensively to finance the purchase of the properties. As interest rates rise, so will the mortgage repayments, which will reduce the rental income available for distribution. REIT’s can be quite volatile investments particular when interest rate volatility picks up in markets.

Natural resources covers a range of investing options from Master Limited Partnerships (MLPs), to timber REITs and even mining companies. For example, MLP’s and Timber REITs, are similar in principle to property REITs, only differing from the fact that the underlying ‘properties’ could be an oil well, or a timber plantation. However, all including, listed mining companies have performed well when prices are rising – often because their underlying assets such as oil are increasing in price too.

Another income generating asset includes infrastructure. These are large scale investment projects which are often a ‘public good’ or ‘municipal project’ such as sewerage, telecoms installations, water or even toll roads. The advantage of these assets is that they provide predictable, long-term income streams that are index-linked i.e. contractually obliged to reset their prices upwards with increases in inflation.

Conclusion:

Inflation is both a fortunate and unfortunate fact of life. Those lucky enough to have owned a home in recent decades have most likely seen a significant increase in the value of their properties. Unfortunately, inflation also means a general increase in the prices of goods and services we all buy. If therefore our investments remain kept under a mattress, the value of them or cash will not increase, whereas the prices of other goods does, meaning that those monies do not stretch as far. They have been impacted by ‘falling purchasing power’.

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The good news is that it is possible to protect against inflation by targeting specific investments. Given decades of generally subdued inflation, few investors have given much thought to protecting their portfolios against rapidly rising prices. The welcome benefit of that though, is that many investments which do offer hedges against inflation would be are attractively priced when compared to the outperforming ‘tech stocks’ of recent years for example.

Real Assets are historically cheap versus Financial Assets

Chart 3

Our view is that the best means of building a portfolio which protects against inflation, is a ‘multi-asset’ one, spread across multiple strategies and actively managed. Inevitably some market volatility will be felt in the prices of certain inflation sensitive assets, and therefore, the means of ‘hedging out’ market volatility should also be considered.

However, having factored in those considerations, investors will then benefit from a portfolio which will hold its purchasing power, generate real returns over the long term and be less correlated to traditional assets into the bargain.

Visit www.nebafinancialsolutions.com to view our Structured Products and UCITS Funds http://www.nebafinancialsolutions.com/Risk-Rated-Portfolio-DFMhttp://www.nebafinancialsolutions.com/real-asset-fund

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