Inflation: The biggest risk facing investors over the next year

Consumer demand and rising input costs expected to see inflation spike from 2020 lows

Jamie Gordon

US dollar inflation

How to play a potential spike in inflation is one of the biggest questions facing investment houses over the next 12 months amid a backdrop of aggressive central bank monetary policy and economies slowly starting to recover from the coronavirus pandemic.

One narrative is that a combination of central bank stimulus, helicopter money from governments, and individuals’ cash savings will be unleashed once lockdown measures are eased and pent-up consumer demand will be allowed to express itself.

While some might expect a repeat of the post-2008 inflationary environment, where, even with quantitative easing, unemployment meant that a consumption-led recovery was muted at best, investors warn this time is different.

We are updating our asset allocation and inflation is a key theme,” Matt Brennan, head of passive portfolios at AJ Bell, said.

The UK currently leads the way for vaccine rollouts in large countries, and it is expected that consumers will make up for lost time once Prime Minister Boris Johnson lifts what he has committed to being the final lockdown. 

Elsewhere, the eurozone saw underlying prices increase at their fastest pace in five years, while in the US retail sales saw their third-largest monthly jump in two decades. On the latter, there is also the very real consideration that a $1.9trn Biden stimulus would mean most Americans would receive cheques for $1,400 – though it is doubtful the current proposal will pass unamended. 

Regarding market inputs, early signs of inflation ticking upwards are already on show. Brent crude hit its one-year high this week; space on cargo ships costs 180% more than it did a year ago; and January manufacturing PMI data showed that the prices paid for raw materials were at their highest since April 2011, according to Saxo Bank. 

As consumers express their demand to buy goods and services, and input costs are passed onto consumers, it appears more likely than not that inflation will rise as (the new) normality is tentatively restored. 

In fact, with markets already anticipating a central bank-led interest rates response to rising inflation, US 10-year Treasury yields achieved a yearly high this week – at one point hitting 1.33% versus their lows of 0.50% seen in 2020. This trend of rising bond yields will become more generalised if rising prices force the hand of central bank policymakers.

One way to play this environment is to invest in cyclical equities such as financials which tend to perform well if central banks react to a spike in inflation by hiking interest rates. This could be a driver behind the recent inflows into the sector with the Xtrackers $706m Xtrackers MSCI World Financials UCITS ETF (XDWF) seeing $163m inflows last week.

Investors are also starting to turn to commodities and inflation-linked bonds as a way of hedging against rising inflation. Highlighting this, the $4.3bn Lyxor Core US TIPS UCITS ETF (TIPG) has seen $1.7bn inflows over the past 12 months.

As Peter Sleep, senior investment manager at 7IM, said: “The best inflation hedge is inflation linked bonds, issued not only by the UK government but also by other creditworthy governments like the US and those in the EU.

“These bonds have done well and look pricey, but if inflation really does come along they will preserve the real value of your investment.”

The benefit of these inflation-linked bonds – referred to as ‘linkers’ in the UK and offered as Treasury Inflation-Protected Securities (TIPS) in the US – is that yields track inflation rates. For instance, should inflation rates rise, the amount of money repaid to the bondholder (principal value) upon the bond’s maturity will also increase.

Sleep highlighted the $75m Lyxor Core FTSE Actuaries UK Gilts Inflation-Linked UCITS ETF (GILI) as a good way of protecting against UK inflation.

Elsewhere, more innovative strategies have hit the European ETF market recently including the $29m Tabula US Enhanced Inflation UCITS ETF (TINF) which combines Treasury Inflation-Protected Securities (TIPS) and US inflation expectations through breakevens.

One move made by AJ Bell’s Brennan has been to shorten the duration in the fixed income segment of his portfolio to protect against real yield increases “that usually accompanies inflation increases”.

“There are obviously some complex products on the market such as TINF but we like to keep it straightforward,” Brennan added. “Within our equities we like to find sectors where we feel they are well positioned to pass on inflation.”

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