...if the inflation dog does bark?


Matt Gibson


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Inflation is back!

…has been a warning from many different people at many different times over the past 30 years and none have proved correct – or not to any significant extent.

Is this time different? Here at LCP, we’ve been debating a renewed threat of inflation – views were mixed! My colleague Dan Mikulskis has written a piece on the arguments why it may, or may not, be an issue in the coming years.

The debate rages on, but from an investor’s point of view, you don’t have to forecast rampant inflation to think the risk of inflation has risen. And in that case, it’s worth reviewing what you can do to insulate yourself and maintain the real spending power of your investments.

If you’re a defined benefit trustee, you probably look at the inflation sensitivity of your benefit liabilities regularly and possibly match all or part of it with government backed index-linked bonds, or derivatives of them. Other investors, however, may not have considered inflation a real threat for some time – it’s been maintained at such a steady, low level that perhaps we’ve become complacent.

Data in developed markets on which assets do well and which do badly during periods of unexpectedly high inflation is all fairly dated, given the three or four decades we’ve experienced of relative price stability.

Emerging markets and older data offer some insights, and we can draw some conclusions based on an understanding of the drivers of returns.

LCP clarity:

Inflation risk looms. Some assets would fare better than others.

LCP insight:

Make sure to review your portfolio for its robustness to higher levels of inflation.

Get in touch with our experts if you would like help with this.

"Some formerly niche assets are becoming more mainstream such as social housing, ground rents or income strips. These often have inflation links or drivers.​"

Matt Gibson


What would do well with unexpected inflation?

Let’s start with the obvious one – inflation-linked bonds lock in a real return and cashflow that increase if inflation rises. They are, however, generally very expensive; for government issues, that return you’ve locked in is a return that doesn’t keep up with inflation; it’s a few percent below the inflation rate. Some company issues, and some bonds backed by infrastructure and real estate assets are inflation linked and offer better returns.

Property and infrastructure sometimes have ‘rental’ contracts that are explicitly linked to inflation. Even those assets that don’t have that explicit link, you expect the cashflows, and hence their value, to rise in-line with inflation over the long term. These assets, however, may have other problems. Our view is that some parts of the UK property market are fundamentally challenged and will be for some time. Changing working and retail patterns as we eradicate, or learn to live with, Covid-19 are likely to reduce demand for office and retail space affecting this market; we prefer global property allocations. Other sectors such as residential, industrial and logistics buildings look more attractive in the UK and have a strong case for inflation-related drivers. Some formerly niche assets are becoming more mainstream such as social housing, ground rents or income strips. These often have inflation links or drivers. Some of the assets described here are only available in the private markets, but the listed market in property or infrastructure has greatly expanded, offering investment opportunities for individual investors in these areas as well as large asset owners.

Moving further away from an explicit match with inflation bring us on to equities. The cashflows you receive as an owner of a business should rise when inflation is high. These rises won’t match year-on-year, but over time the real value of a portfolio of equities should keep pace with inflation. Equities, though, are volatile, the link to inflation is loose, and they expose the investor to other risks.

Commodity prices should keep up with general inflation in the long run. Many investors dislike them for the volatile prices, lack of direct correlation with inflation, and the fact that they don’t generate an income. The latter point is perhaps a historic concern only; with many other assets offering low or even negative yields, commodities’ relative disadvantage has all but disappeared.

Gold holds a special place for many investors worried about inflation. Fifty years ago, the US dollar was explicitly backed by gold held by the US Treasury. To some, the current system of money backed only by a government promise is a failing experiment: gold, or a currency that can be exchanged for a set amount of gold, is the superior system. This is perhaps a rather extreme view, but gold certainly has maintained its spending power for thousands of years – and that’s unlikely to change in our lifetimes. It doesn’t though have any explicit link to inflation, and over even relatively long-term periods can fall behind (gold fell in value by over 75% between the 1980s and early 2000s, a period where there was plenty of inflation).

Some investors are also looking at cryptocurrencies as an alternative to gold. Supporters argue that Bitcoin and similar cryptocurrencies have limited issuance and so won’t lose value if there is high inflation. I’m not convinced by this argument; I think a sustainable currency requires other features and acceptance to be a store of value (we discussed this in another blog here). The short history of cryptocurrencies means that we'll have to wait many more years before we have any real evidence either way.

What would do badly in higher inflation?

If there are few assets we can identify that look good value as an inflation hedge, perhaps the best we can do is reduce exposure to those that may not do so well.

Long-dated fixed income bonds can quickly lose real value during inflationary periods. A bond maturing with a £100 pay-off in 20 years that then suffers 4%pa inflation will only provide £45 of spending power at maturity.

Floating rate debt payments, common in private corporate debt, real estate and infrastructure debt, may do better at keeping up with inflation, but only if central bank base rates also rise. With the economy in the current situation, that might not be the case; central banks may be more tolerant of inflation and will be happy to keep their interest rates lower.

You don’t have to believe inflation will return – just that it’s now more likely

Worrying about inflation rising perhaps seems a little premature – the economy is still in a perilous state and not usually the sort of conditions that lead to inflation. Is it too early to worry about it? Maybe, but by the time other investors start worrying, you’re probably too late.

My view is that the risk of inflation is rising – I’m not forecasting it will rise, but I do think it’s worth considering how your portfolio might behave if it were to take off. In the same way that many people considered a ‘leave’ Brexit result unlikely in 2016, those investors that included a hedge just in case the UK did vote to leave didn’t regret their decision.

Geek notes – drunk men and dogs

One of the common measures used to judge how well an asset matches inflation (or any other measure) is how well correlated they are. This is a measure of how well the asset and inflation move together, or how frequently and to what extent a rise or fall inflation happens at the same time as a rise or fall in the asset value.

But there are some flaws with this, illustrated by the analogy of a drunk man staggering home with his dog on a lead. Every time the man lurches left, the dog jumps right; when the man staggers right, the dog deftly steps left. The movements of the dog and the man are uncorrelated or even negatively correlated. But… the man and the dog are never more than a lead length apart and both end up at home in the end.

Some assets are highly correlated with inflation, such as inflation-linked bonds. Others exhibit similar patterns to the man with his dog. They may not be correlated with inflation, but they can still be a good ‘match’ in the sense that, over the long term, they broadly rise in value together.

Inflation may be the ‘dog that didn’t bark’, and perhaps it’s keeping out of the way for now, but be prepared for it to trip you!

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