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Point of View

Protecting your portfolio from inflation

Cynthia Bowring, Portfolio Manager 

While we’re a very long way from a high inflationary environment, the UK’s consumer price index (CPI) came in at 2.9% in August – 0.9% above the Bank of England’s target of 2%, and well above the 0% figure of two years ago. Although we don’t think this trend will continue (it is above target mostly due to the fall in sterling following the Brexit vote and we expect this impact to fade over time, back towards the government’s target of 2%), we thought we would look at the impact of rising inflation on investors, and how we manage portfolios to mitigate the risk it imposes.

The impact of low interest rates, and low inflation

Since March 2009, consumers and businesses have enjoyed the bank base interest rate of 0.5% or less, enabling small businesses to flourish due to the availability of cheap credit, and making homeowners feel better off due to the fall in repayments on their mortgages.
 
But for savers and investors, this low interest rate environment has not been so accommodating, and this has become more pronounced as inflation has increased. For those wishing to make decent returns on their savings, they have been forced to look beyond high street accounts – perhaps to government and high quality corporate bonds, or equities for those with a higher risk appetite.
 
This 'hunt for yield' has been well publicised and, as portfolio managers, it’s our job to protect our clients’ wealth from rising inflation at a time when interest rates, and therefore bank account rates, are unlikely to rise dramatically in the near term. So how do we go about it?

The role of bonds

As any textbook will tell you, higher inflation causes bond prices to fall, as investors worry that bond yields will not keep pace with the higher interest rates required to tackle rising inflation. Despite this, government and corporate bonds play an important role within a diversified portfolio due to their negative correlation to equities, lower volatility and relatively secure income stream.
 
With higher interest rates anticipated in the future (albeit in the medium-term future), how do we alter our bond exposure to minimise interest rate risk? Firstly, we reduce the duration of the bonds that we hold. In other words, we reduce the time to maturity of the bond, and therefore reduce its sensitivity to interest rate rises. Secondly, we hold index-linked bonds as their capital value and coupons are linked to inflation so, in broad terms, as inflation rises, so does the level of income received. 

Equities: a natural hedge against inflation

Our portfolios also tend to hold a variety of real assets, such as equities, because they have an intrinsic value due to the company’s profits, tangible assets or intellectual value. Indeed, equities provide most of the capital growth within a portfolio, while also providing a built-in hedge against inflation. This is because, while companies are initially impacted by the higher price of materials, inflation-driven costs are ultimately passed onto the consumer in the form of higher prices.  We can also be confident that dividend-paying companies will work to maintain or grow their dividends, and companies that reinvest for growth will continue to do so, to maintain investor confidence.
 
If inflation is expected, and does not rise too rapidly, companies can adapt. A diversified portfolio benefits from having exposure to an asset class which can factor in higher inflation and benefit from it. When selecting equities, either directly or via collectives, we ensure that we invest our clients' money in high quality companies which have experienced inflationary periods, and have proven that they can manage these conditions. 

Inflation outlook

Inflation, when it rises rapidly, will tend to take both businesses and consumers by surprise. However, our expectation is for a moderation of inflation towards the Bank of England's target rate of 2%. In this environment, a well-diversified portfolio remains one of the best ways to protect wealth against rising prices, and we will continue to run our clients' portfolios accordingly. 

Sanlam is a trading name of Sanlam Private Investments (UK) Ltd (registered in England and Wales 2041819; Registered Office: 16 South Park, Sevenoaks, Kent, TN13 1AN), Sanlam Wealth Planning UK Ltd, registered in England and Wales 3879955, and English Mutual Limited, registered in England and Wales 6685913 (Registered Offices: St Bartholomew’s House, Lewins Mead, Bristol, BS1 2NH), all of which are authorised and regulated by the Financial Conduct Authority. The articles within this publication are for information purposes and should not be treated as a forecast, research or advice to buy or sell any particular investment or to adopt any investment strategy. Any views expressed are based on information received from a variety of sources which we believe to be reliable, but are not guaranteed as to accuracy or completeness by Sanlam. Any expressions of opinion are subject to change without notice. Reproduction is not allowed in whole or in part without prior written agreement from Sanlam. Past performance is not a reliable indicator of future results. Investing involves risk and the value of investments, and the income from them, may fall as well as rise and are not guaranteed. Investors may not get back the original amount invested.
                                                      

Investing involves risk and the value of investments and the income from them may fall as well as rise and are not guaranteed. Investors may not get back the original amount invested.