There is a growing school of thought that the measures taken to stimulate the economy in the wake of the pandemic will ultimately result in higher inflation. Policy responses around the world have been far more aggressive than after the global financial crisis so inflation expectations could pick up quickly and if they do it would have huge ramifications for investment returns.
There is a good chance that there will be more fiscal stimulus to come, with government debt levels rising even further. In an ideal world it would be possible to grow our way out of the crisis, but this seems unlikely and as defaulting on the debt would be too painful it seems that financial repression is the only way to make it more manageable.
Financial repression enables the government to channel funds from the private sector to themselves as a form of debt reduction. This can be achieved in various ways including pinning bond yields to low levels, thereby keeping interest rates below where they should be and penalising savers in the process.
These sorts of policies would require more ongoing intervention by central banks that would effectively become the financing arm of their respective governments. The problem is that once the public sector spending taps are turned on it would be hard to turn them off until inflation finally becomes a major issue.
How much inflation will we get?
Ben Yearsley, a director at Shore Financial Planning, says that he thought that inflation would return after the first bout of Quantitative Easing (QE) in 2009, then after QE2 and QE3, but it never materialised.
“This time the policy response is far bigger and quicker than during the Global Financial Crisis (GFC) and the overall level of debt in the world is that much greater, so if inflation did come back central banks wouldn’t be able to increase interest rates to combat it,” says Yearsley. “However, I doubt if it will return in a meaningful way, as with more unemployment, where is the pressure on wages?”
It is a view shared by Ryan Hughes, head of active portfolios at AJ Bell, who says that the enormous amount of stimulus being provided by central banks ultimately has to have an inflationary impact.
“It makes sense that some level of inflation has to come through and that is desirable by governments to help them inflate away the huge debt mountains that have built up,” argues Hughes. “Given the very low base, it is prudent to expect inflation to increase over the next couple of years, but it is highly likely to remain below the two percent level.”
It’s not nailed on that high inflation will return, yet the chances are greater than after the GFC and it is important that investors are aware of the risks and plan accordingly. If there was a significant increase it would provide a tailwind for some asset classes and a headwind for others.
The most notable beneficiary would be gold, which I covered in depth in my recent article, the best gold and gold-mining funds. This has now surpassed its previous all-time high of $1,921 set in September 2011 and looks set to go well beyond $2,000 per troy ounce.
Yearsley says that the other obvious winners from higher inflation would be infrastructure and inflation-linked bonds: “Normal corporate bonds are the clear area to avoid as fixed interest is effectively eroded, while government bonds would also suffer.”
Multi-asset investment trusts
There are three excellent defensively-oriented, multi-asset investment trusts and they have each positioned their portfolios to guard against the return of inflation. One of them, the £450m Ruffer Investment Company (LON:RICA), has recently been rated a buy by the analysts at Investec (see fund of the month below).
Yearsley and Hughes both prefer the £1.2bn Personal Assets Trust (LON:PNL), which aims to maintain and grow the real value of your money over time. It invests in high quality companies, gold and index-linked government bonds and has recently released its annual report for the year ended 30 April.
During the reporting period the fund generated a NAV total return of 6.7%, which compares favourably to the fall of 16.7% in the FTSE All-Share index. The portfolio has significant weightings in US Treasury Inflation Protected Securities (TIPS), UK gilts and gold, while the equity exposure consists of UK and US blue chip stocks.
“The high quality equities include the likes of Microsoft, Nestle and Unilever, all of which have pricing power that enables them to pass on rising costs to consumers given the strength of their business franchises. This would become very valuable in a rising inflation environment,” explains Hughes.
Writing in the accounts, the manager, Sebastian Lyon, says that as money supply is pumped up to offset deflationary forces, there will be little if any risk of austerity to follow. “In contrast to the last downturn, the lack of a fiscal handbrake means that inflationary risks are likely to rise. Equity investors, who for 30 years have been used to falling interest rates and declining inflation, still seem oblivious of this possible outcome.”
The other option in this area is the £515m Capital Gearing Trust (LON:CGT) where the managers have recently highlighted the astonishing extent of government policy support.
Writing in the accounts they said: “Monetary finance of government spending will be a sustained feature and will not be deemed an issue so long as inflation does not rise to problematic levels. However, this very mind-set significantly increases the risk of inflation actually becoming problematic.”
They have taken a cautious approach and at the end of June had just 38% invested in funds and equities, with 27% in index-linked government bonds, 13% in conventional government bonds and 14% in preference shares and corporate debt. The other eight percent was in cash and gold.
Rob Morgan, an investment analyst at Charles Stanley, says that infrastructure assets often have a certain amount of contractual inflation protection built-in and can potentially provide an attractive, income-oriented return.
“Large, diversified investment trusts such as International Public Partnerships (LON:INPP), HICL (LON:HICL)and 3i Infrastructure (LON:3IN) invest across a wide range of infrastructure assets in the UK and overseas,” says Morgan. “Their dividends are presently attractive and well covered by predicted earnings and reserves, so they can potentially provide investors with a decent return.”
The main problem with these funds is that they are trading on large premiums to their net asset values (NAVs). These currently stand at 13%, 11% and 17% respectively.
Morgan says that an alternative option is to invest in a fund that provides exposure to the shares of companies that operate infrastructure or vital utilities. These should offer a broad range of holdings by sector and geography, while still producing a decent income from a flow of underlying dividends.
“One such is the Legg Mason IF ClearBridge Global Infrastructure Income Fund,” adds Morgan. The ClearBridge team are experienced infrastructure specialists based in Australia and have built an impressive record while consistently delivering a decent yield that is currently over five percent.”
Yearsley prefers First State Global Listed Infrastructure that invests in quoted infrastructure companies from around the world. “It offers steady growth with a reasonable yield of two to three percent per annum with many of the underlying assets having some form of inflation linkage.”
If you want a higher level of income he suggests Time UK Infrastructure Income that yields close to five percent and invests in areas such as renewable energy generation, which typically has an explicit inflation link.
All of these infrastructure funds sold-off sharply during the market crash, but have since recovered most of the losses. They offer some of the most tempting yields in the market and should benefit from the return of inflation, although fears of a second wave could result in heightened volatility.
Adrian Lowcock, head of personal investing at Willis Owen, thinks that inflation will happen but it might take a bit of time.
“One aspect that is probably still needed is wage inflation and with unemployment expected to be much higher than in 2019 it could take a few years for employment to pick up and wages to start rising again,” argues Lowcock.
Lowcock says that if inflation is very high then inflation-linked bonds and gold would be the first port of call, but if it is more modest then equities can deliver. “Companies which offer essentials or are able to pass on price rises to their customers tend to do well in a modest inflationary environment.”
For this sort of scenario he recommends Man GLG Undervalued Assets, a value-oriented UK fund. It is managed by Henry Dixon who looks for companies whose value is under-appreciated by the market and this includes areas that could benefit from a return of inflation as expectations are currently low.
Morgan says that companies with ‘pricing power’, whose products and services are in strong demand, can put up their prices to reflect higher costs and should in theory be well placed to cope.
“Funds that have a history of targeting and harnessing the returns from such businesses include Liontrust Special Situations that invests in the UK and Rathbone Global Opportunities, which offers an international exposure.”
If the inflation is partly caused by higher commodity prices then a fund with exposure to the mining and energy sectors would be a decent option. In this situation Morgan suggests the BlackRock World Mining (LON:BRWM) investment trust that is currently yielding over five percent.
“It has some gearing, which makes it more risky than an equivalent open ended fund,” argues Morgan, “but the shares are currently at a discount to NAV of around ten percent.”
BRWM has around a third of its portfolio in gold miners, while another third is invested in large diversified mining stocks, with the biggest holdings including the likes of Rio Tinto, BHP, Barrick Gold, Newmont Mining and Anglo American. It is a volatile option, but could do well in an inflationary environment.
There is a good chance that the measures taken to stimulate the economy in the wake of the pandemic will ultimately result in higher inflation. It is therefore important to protect your portfolio by investing in those funds that can benefit from this sort of environment, as there will be many parts of the market that would suffer.
FUND OF THE MONTH
The Ruffer Investment Company (LON:RICA) has successfully protected investors’ capital during both the major bear markets since it was launched in 2004 and has produced some decent growth with an annualised NAV total return since inception of 7.4%. It has recently been rated a buy by the analysts at Investec.
In its annual update released at the end of June, the managers said that there is an epoch-defining tug-of-war going on between the unprecedented interventions of governments and central banks versus the disruption to the global economy caused by the pandemic.
“One of the most obvious consequences is that the inflationary endgame is closer and more likely than it was six months ago. Borrowing is currently going through the roof in order to fund the emergency measures put in place by governments. Previously one might have said that keeping interest rates below the rate of inflation (financial repression) was desirable, now it is a necessity if these promises are going to be affordable.”
The managers think that the financial repression and money printing by central banks to counter the impact of the coronavirus will act as an accelerant into a new regime of high economic and market volatility and higher inflation.
In order to deal with this they have put together a portfolio of index-linked bonds, gold and value stocks (which benefit from stimulated GDP growth). There is also significant protection against market calamity in the form of credit protection and options, which sets it apart from other similar funds.
The cost of maintaining this sort of protection had acted as a headwind for the fund, but proved its worth during the market crash as it enabled the shares to more or less hold their value. Year-to-date they are up about ten percent, which suggests they could be a pretty safe way to benefit from the increase in inflation.