Inflation-proof your portfolio – Alphaniketan

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With the outbreak of coronavirus pandemic, central banks globally are facing a tightrope walk between inflation and economic growth.

Earlier this week USA reported largest gain of 0.9% (for June 2021) in consumer prices in 13 years, pacing 5.4% year-on-year. Reserve Bank of India too reported retail inflation of 6.26% for June 2021, which has dropped from the 7% rate of November 2021.

The numbers are beyond the tolerance zone of both Federal Reserve and RBI and are likely to stay at an elevated level. As the largest asset manager Black Rock’s Larry Fink has indicated US inflation could not just breach 2% but stay at 3.5-4%.

What led to higher inflation?

While India is an exception, in developed countries inflation concerns were absent for nearly three decades and is now rearing its head again.

High food prices, increasing logistics expenses, costly fuel and strained supply chains have led to steady price rise of goods and services – also termed inflation.

Source: IMF

Even as there is a demand pull, the increase in general money supply too has a role to play in enhancing the inflationary pressures. For instance, the dollar circulation in USA got a 20% boost by Federal Reserve that launched a $1.9 trillion monetary aid package.  Even the Indian Government offered an economic stimulus amounting to INR 6 trillion ($79 billion). Several other tax and aid packages were announced globally.

As a result of the economic aids, Government debt shot to 142% of the GDP among G7 countries by end-2020 as against 119% in December 2019, which too has played a significant role in escalating inflation.

Tweak portfolio

If the conservative inflation forecasts are anything to go by, the investment portfolio and the asset classes would have to be modified to tackle inflation.

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This is because to combat inflation Central Banks use the age-old method of raising interest rates. The action of high inflation, coupled with higher interest rates affects the corporate earnings.

Let us understand how the two pan out in different scenarios. If inflation rises, Neeraj – who used to spend Rs 1,000 to purchase basic goods, would now have to shell out Rs 1,500 to buy the same items. Since the purchasing power of his money has decreased, he would expect a higher rate of return from his investments to maintain his purchasing power.

At the same time Neeraj would also avoid stashing cash at home as its value would decrease. So, he is more likely to invest this amount. So, he would chase investments that yield higher returns and be willing to pay less for company’s earnings. As a result, when inflation is high, price earnings (PE) ratios are low and lower the PE, higher is the return.

But when inflation is moderate, the expectations of returns on investments is low. As a result of this low inflation, Neeraj would be willing to pay more for a company’s earnings leading to a high PE ratio.

Real returns fight

Understand that these high inflationary periods would lead to lowest real returns – which is nothing but the rate of return, less inflation. Unless you exercise caution in your investment strategy and take proactive steps your wealth would erode under the force of inflation.

The first money move to make in this high inflation period is to assess fixed-rate options for debt – be it home, car or business loan – at these historically low rates. Along with debt refinancing, you should also move out of long-term bonds, where you lock into interest rates for 20-30 years as the value would degrade for decades together yielding the principal amount that would be worth far less than it is today.

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Where to invest?

To fetch returns on investments that outpace inflation you would have to seek options that are likely to move in tandem with inflation. Some options to consider are:

Inflation-linked bonds

Different countries offer bonds that are linked to inflation. First introduced in United Kingdom, these inflation-linked bonds are now popular in USA, Sweden, Canada, Mexico and even Australia. So, for instance, the interest rates offered under US Treasury Inflation-Protected Securities increase when the inflation rate is high and reduce in a deflationary scenario.

Commodities

Tangible goods such as gold, silver, oil, gas or even crops traditionally tend to be your best hedge against inflation as their prices increase when interest rates are high. During economic downturns more people flock to these real assets shooting their prices.

Another rationale is that since the currencies are degrading, the value lies in gold, silver and other natural resources.

Real estate

Since interest rates are high, fewer people tend to purchase properties as they move out of the affordability range. Hence, real estate is another investment option you should explore during high inflation phases. If you cannot afford to purchase entire piece of land or property real estate investment trusts (REIT) can be considered, which consist of a portfolio of properties and offer returns in line with real-estate as an asset.

Stocks

Exercise caution while picking the right stocks. Companies would be forced to increase the prices of their products due to rising raw material and labour costs. But if this price rise dents the demand of its products, then the stock would be negatively impacted. So, stay away from stocks linked to discretionary spending such as consumer durable goods, real-estate developers, etc.

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Instead, invest in FMCG manufacturers, real-estate leasing companies, gold-mining firms and those involved in commodities.

Cryptocurrency

While there is a furore over the legality of cryptocurrency, it has become the hot favourite among investors seeking high returns. There is no historic record of how it would perform during inflationary phases, but the fact that these are limited in number and money would be chasing the non-currency options, there is a likelihood of a price rise in this emerging investment option.

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