11 Sep Protecting your portfolio against high inflation or deflationRead Time: 5 minutes
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Several weeks ago I threatened a second part to the piece about whether we were in for a period of high inflation or deflation which would look at the types of investment that your portfolio might usefully hold to provide some protection from each scenario. For various reasons it didn’t follow immediately but hopefully better late than never, here it is now.
Defences against high inflation
Historic hedges against inflation include shares in growth companies, commodities including gold, overseas bonds and inflation-linked bonds.
Overseas bonds provide exposure to economies which may not be experiencing the same inflation as the domestic economy as not all countries experience the same conditions at the same time. It may be worthwhile to remove or reduce the exchange rate risk inherent in this by using a fund which hedges back currency exposure to that of your own portfolio. Currency fluctuations can have a far greater impact on the overseas bonds in a portfolio than on the overseas equities in it.
Inflation-linked bonds were a response to the high inflation of the 1970s (although the first was issued in the 18th century) and are mostly issued by governments rather than corporations. Several developed and some emerging market nations issue them, the largest being the US and the UK. Provided that they are purchased at launch and held to maturity, they guarantee a return above inflation over their term, although since they are publicly quoted and traded between those dates, the investor who buys and/or sells in the market is guaranteed only the periodic interest payments and may see a gain or a loss over their own holding period.
Although commodities offer a hedge against inflation, they tend to have extremely volatile prices and these can swamp any real return that might be achieved. There are practical difficulties with obtaining direct exposure to commodity prices cost-effectively and Bloomsbury therefore achieves its exposure via equities, some of which are involved in their extraction, transport and processing. Such companies may be in developed or emerging markets, the latter often being exporters of commodities.
Unlike many investments, gold (and indeed other physical commodities) has no intrinsic value as it produces no income and has no capacity to generate economic activity. Instead, the buyer of gold does so in the expectation of being able to sell at a higher price in the future than they paid. Effectively they require someone else to be more nervous about the future than they are. Gold has exhibited periods of high return in the past but these have tended to be patchy and success depends heavily on when the holding period occurred. Even the long term investor has not necessarily done well from it – based on data from YCharts, measured in US dollars, the annualised post-inflation return to a UK investor over the 40 years to April 2020 is an unimpressive minus 0.5%. Over 30 years, this improves to just over 2% and only over the last 20 years does it rise to a respectable 6.5%. Annualised inflation over all three periods averaged between 2.7 and 4.8%, so while not exactly hyperinflation, hardly high rates. Even so, over 20 years, average annual inflation of 4.8% will reduce the purchasing power of £100 to around £38 so moderate inflation over a long period can be as damaging as a short period of high inflation.
Defences against deflation
The first defence is to have as little debt as possible. This applies whether the borrower is a business or an individual. The former might borrow to fund the purchase of a machine to make widgets but if the market for those widgets declines, it may not be able to earn enough additional revenue to compensate for the cost of the additional debt. The latter generally acquire debt not for funding improved productivity but to acquire assets (a home, a car etc.) but in a deflationary environment, the value of the debt is rising while that of the associated asset may well be falling. Furthermore, if servicing debt depends on earned income and that reduces or stops, it is harder to pay off or even to maintain the debt.
The opposite of debt is cash and if prices are falling, then the purchasing power of cash will be rising. Even though interest rates on cash are currently close to zero (and may well remain so for a prolonged period), the post-inflation return on cash will still be positive if inflation is below zero and so its purchasing power will increase. Those who hold significant cash will be better able to take advantage of those opportunities for acquisitions at bargain prices which present themselves, whether they are a business or an individual. We have always advocated clients holding whatever cash they regard as sufficient to enable them to sleep well at night, even if this compromises their long term financial security.
Other defences against deflation include owning high quality longer term bonds, defensive equities and companies which pay dividends and have sufficient reserves to maintain them. Bonds from strong issuers (those perceived as less likely to default, such as sovereign governments and highly rated corporates) tend to perform better than equities in deflationary environments. Fixed future coupon payments become more valuable and interest rates fall, which makes bonds more attractive and thus their prices tend to rise. As above, holding bonds from overseas rather than just domestic issuers diversifies exposure. The debt of lower quality issuers, however, are less attractive as their fixed interest payments become less affordable over time and there is a greater potential for default.
Equities generally do poorly in a deflationary environment. Those which do hold up tend to be in sectors of the economy with which people have to engage regardless of the situation, such as utilities, food, groceries and drugs. Companies which pay dividends tend to be financially stronger and therefore better able to weather deflation and continue to pay dividends and these can support their share prices should inflation reach a level which causes valuations to stagnate.
Economies can move between inflation and deflation with some rapidity, which makes accurate prediction tricky and the consequences of backing the wrong prediction potentially costly. Trying to position a portfolio to take advantage of such short term changes in the macroeconomic environment is effectively market timing and thus has the same requirements as any other market timing approach:
- Getting the prediction of the economic news correct and
- Getting the prediction of the market’s response to the economic news correct.
Eventually any forecast will be wrong and that may well be the time when there is the most confidence in the forecast being right. Even if there is high inflation (or deflation) in the next 10 years, nobody really knows when either will occur and, equally important for timing decisions, when the change (or changes) between them will occur.
It is also necessary to take account of the costs (in transactions, taxes and being out of the market while trading) incurred, which make it necessary to be right more than half the time in order to end up ahead. With academic studies repeatedly showing how difficult this is, most investors are best served by holding a diversified portfolio that is appropriate to their own objectives and risk profile and only changing it when their own circumstances change.
It is very difficult to identify whether the greater threat comes from inflation or deflation, so Bloomsbury’s approach is to position the portfolios which it manages to allow for both. A typical client with a 30-40-year time horizon will probably experience either or both environments in that timeframe and whether inflation is rising or falling, sticking to their financial plan, spending within their means and maintaining a diversified portfolio provides the best defence against what is always an uncertain future.