No one knows how this extraordinary year will play out but for investors, one thing seems fairly likely – at some point inflation will rise.
As major economies continue to ease lockdown restrictions amid slowing coronavirus cases, the deflationary short-term effects of COVID-19 are likely to be reversed. There’s also likely to be a reawakened post-lockdown demand for goods and services that will push up prices.
Analysts are split on when this will happen, or how high inflation might climb, but a low inflation market has been with us for so long that a spike will be unfamiliar territory to many newer investors.
“We are unprepared for inflation and few of us alive have ever experienced what it’s like to trade in an inflationary environment,” wrote Teun Draaisma and Ben Funnell, co-portfolio managers on Man Group’s DNA team, in an article in the Financial Times.
“Attempting to protect portfolios could mean buying not-so-liquid inflation-linked securities and floating-rate bonds; pursuing value and momentum strategies in equities; and purchasing commodities, gold in particular. We are all going to have to learn to live — like Alice in Wonderland — in a world turned on its head.”
“Attempting to protect portfolios could mean buying not-so-liquid inflation-linked securities and floating-rate bonds; pursuing value and momentum strategies in equities; and purchasing commodities, gold in particular” - Teun Draaisma and Ben Funnell, co-portfolio managers on Man Group’s DNA team
But higher inflation tends to lead to a downturn in income-oriented or high-dividend growth stocks. It’s also likely to make equities more volatile. Any continuation of fiscal stimulus is also set to push bond yields towards zero – and in some markets into negative territory.
To keep inflation levels in Europe below 2%, Christine Lagarde, president of the European Central Bank, decided to keep interest rates at 0% on 16 July. Meanwhile, Jerome Powell, chairman of the Federal Reserve, has pledged not to raise rates until inflation hits 2%.
So, how do investors protect against, and even profit, from higher inflation markets?
An inflation-proof portfolio
Value investing has had bad press over the last few years but a lower price to earnings (P/E) ratio stock may look more like a more stable option in these topsy-turvy times. Value stocks have been particularly hard hit during the coronavirus pandemic. As a result, research by Credit Suisse predicts earnings in value stocks to fall 42% by the end of 2020, compared with a 13% drop in growth stocks.
However, nearly five months on from the initial COVID market crash, a sift through the rubble of value stocks could unearth companies and sectors that have not only survived to demonstrate durability, but could prove themselves solid investments over the longer term. Indeed, investing in a company with a current low P/E ratio could prove to be a bargain if they survive while sector rivals fail.
Take the banking sector for instance – majority of which are cheap at the moment. Bank Of America [BAC], which has a P/E of 12.7 and a share price of $26.56 as of 10 August, is down 23.56% YTD. Meanwhile, JPMorgan Chase [JPM], which has a P/E ratio of 13.4, is down 25.86% YTD at $100 a share.
Provisions for credit losses have hit each bank’s share price and if coronavirus cases spike for a second time later in the year, these prices are likely not to recover for a while yet. But when inflation climbs, revenue will rise and loan-loss provisions will ultimately decrease, giving the bank profit growth potential that makes today’s prices look like a real bargain.
Then there’s construction. The sector ground to a halt between March and July, which will certainly have scuppered any short-term profit opportunities. Nevertheless, the UK still has a shortage of homes. Estate agent Savills predicts house prices to rise 15% by 2024, placing housebuilders such as Persimmon [PSN] in an interesting long-term option.
Outside of equities, there are other ways to diversify a portfolio to protect against a rise in inflation.
Hedging against inflation with gold
Often thought of as a safe haven asset in a crisis, owning gold has already proved a comfort for investors in 2020. Interest has been accelerated by depressed bond yields, sending the value of the precious metal up 32% since the turn of the year to break the historic $2,000-an-ounce barrier on 4 August.
It will also prove safe for different reasons as economies pick up. As prices rise, currency value decreases, and an ounce of gold becomes more expensive. But although this could give you a very short-term gain, it’s not a perfect hedge – if inflation gets too high and banks start raising interest rates, other asset classes will pay yields, which gold obviously does not.
“The root cause (behind the rally) is uncertainty,” George Cheveley, a fund manager at Ninety One told the Financial Times. “It’s uncertainty about whether the world plunges into recession next year or recovers, spurred on stimulus money. When you think of both of those outcomes, gold has a place.”
“It’s uncertainty about whether the world plunges into recession next year or recovers, spurred on stimulus money. When you think of both of those outcomes, gold has a place” - George Cheveley, a fund manager at Ninety One
Guard against inflation with tangible assets
A rise in inflation tends to hike up property prices and rental income. Real Estate Investment Trusts (REITs) will reward in such times, notably because many leases are tied to inflation. But be mindful that some REITs are more effective hedges than others.
There’s more return in real estate sectors with shorter-term lease structures, such as hotels and apartments, which can react to the market and increase rates more quickly than REITs with longer lease terms such as properties in the healthcare sector.
Oil’s correlation with the inflation rate
The end of lockdown in many economies means a higher demand for goods and services, and as inflation grows with that demand, so does the price of commodities. They have an inherent value that tends to stay steady throughout the most turbulent times.
Oil, in particular, is making a steady recovery after falling into negative territory ($-37) earlier this year. The Energy Information Administration expects prices to average $41 for the rest of the year and push up to $51 in 2021.
“There are likely to be several quarters of deflation resulting from the supply shock. But it’s precisely because inflationary signals are not yet fully visible that we need to be preparing ourselves now” - Man Group’s Draaisma and Funnell
“It may seem like a strange time to be thinking about inflation – just as the world is in shut-down and deflationary signals abound,” Man Group’s Draaisma and Funnell said. “There are likely to be several quarters of deflation resulting from the supply shock. But it’s precisely because inflationary signals are not yet fully visible that we need to be preparing ourselves now.”