Inflation might be on its way – but transitory inflation might be more likely than sustained inflation.
Be smart about which inflation-linked assets you buy – some might offer better value than others.
Readers may recall The Automatic’s 2006 hit single which went “What’s that coming over the hill? Is it a monster? Is it a monster?” It’s one of those slightly annoying songs that once it’s in your head, well it’s hard to stop hearing it. All the current talk of inflation in the investment industry reminds me of the monster – is it coming and what should we do? Safe to say all this talk of inflation is like that song – it’s stuck in my head!
Is inflation on its way?
As discussed in my colleague Dan’s article, there are lots of reasons that inflation might be coming. But there are also lots of reasons that inflation might not be coming.
Added to this, there are other idiosyncrasies at play. For example, as discussed in Lee Dodd’s latest blog, check out the shipping crisis where shipping costs have been squeezed by a set of exceptional circumstances or the recent increase in the oil price.
So where do I land on the question: ‘is inflation on its way’? I think it might be. That probably doesn’t seem like a particularly helpful statement – maybe a bit of sitting on the fence. However, I think investors should be taking a measured approach to this. There is nothing wrong with being humble, saying there is a lot going on and it’s hard to disentangle.
So, an approach whereby we accept a higher probability of inflation, but maybe don’t position our portfolio for the German hyperinflation of the 1920s (where massive increases in prices made money, and financial assets, less valuable) – this seems to balance the heightened risks of higher inflation against the possibility that the inflation doesn’t materialise.
What type of monster are we talking about?
It is important to be clear in what we mean by inflation potentially being on the horizon. For example, a short-term inflationary blip that subsides in a year or so is very different from a prolonged period of inflation. I think what is clear is that a short-term inflationary shock is likelier than prolonged runaway inflation.
Why is that? A lot of the possible drivers of this bout of inflation are themselves short-term and will not continue:
- pandemic-induced savings will dwindle
- the extraordinary fiscal and monetary policy will subside – though we have been saying this for a while…
- and the current supply chain/commodity price (see shipping and oil above) characteristics at play won’t last forever.
Over the long term, I would expect inflation to be controlled by monetary policy, especially given most central banks are mandated to target low, stable levels of inflation.
As per my humble investor mantra, this doesn’t mean to say I don’t think holding some long-term inflation-linked assets is a bad idea – I could be wrong about long-term inflation too!
How to protect my portfolio?
The best asset to protect against inflation is long-dated, inflation-linked government bonds – these come with an explicit link to inflation and extremely low default risk. What’s not to love? Well I think, they are expensive, perhaps very expensive.
From looking at the relative pricing between fixed-interest government bonds and inflation-linked government bonds, one can derive a “market-estimate” of future inflation. This can also be thought of as the inflation rate an investor “locks into” by purchasing an inflation-linked government bond.
An alternative estimate of future inflation might be the Bank of England’s inflation target of 2% pa. As shown in the chart, investors in inflation-linked government bonds are implicitly accepting paying a premium of about 1.5% pa to insure the risk that inflation is higher than the BoE target.
"Investors in inflation-linked government bonds are explicitly accepting paying a premium of about 1.5% pa to insure the risk that inflation is higher than the BoE target."
This 1.5% pa premium seems a lot to me. Maybe the market knows something I don’t know about long-term inflation? Or my preferred explanation is that there’s a large supply/demand imbalance for UK inflation-linked government bonds (as a lot of UK institutional investors are encouraged to buy inflation-linked assets as a hedge for liabilities and the UK Government doesn’t want a large inflation exposure on its books).
Given the above, I wouldn’t want to rely solely on inflation-linked government bonds for inflation protection. The good news is that there are a few other great options in the investor’s toolkit:
Land, property values and rental income all have historically displayed a strong correlation to inflation. Investors worried about property headwinds may wish to consider long-lease property, whereby returns are more dependent on long-term, contractual rental increases with an explicit inflation link and less reliant on underlying real estate values.
Infrastructure is a vast asset class, but most assets have a link to inflation, sometimes driven by regulation or energy prices.
Over the long term, equities should theoretically rise in line with inflation (after all it could be increases to company’s prices that are driving inflation). However, a short-term inflation spike could cause a market pullback, so investors should be cognisant of their timeframes and tolerance for short-term risks.
Gold, commodities and cryptocurrencies
These assets could take an entire blog to cover so I’ll keep this brief! Theoretically, these assets could be a hedge for inflation (for example, given their finite supply, their value should increase in a world where money becomes less valuable). At the same time, there is some debate about the merits of investing in assets with varying degrees of intrinsic value and little outlook for benefiting from economic growth.
Back to that song that is still stuck in my head, “what’s that coming over the hill?”. It might just be inflation. So, we might all want to consider what happens if inflation is coming and what assets best provide the protection you need to make sure it doesn’t turn into a monster for our portfolios.