How do you protect your portfolio from inflation? Is it something investors should be worried about in a COVID-19 world, and when many analysts including global central banks have a sanguine view of price rises?
The short answers are by finding investments that rise alongside prices; and yes.
On the ground, many companies are reporting higher costs. Supply chains, and particularly higher shipping costs, are causing price pressures. In some cases, shipping costs have doubled since the end of 20191.
There are also labour shortages coming through the economy. This should be a positive for wage inflation, and it’s something the Reserve Bank has been trying to achieve for a couple of years2.
But many economists seem unconcerned about the potential rise in inflation, often citing the current lockdown-induced slowdown. Some are even talking about a recession. We don’t believe we are in a recession. We are in a lockdown.
There may be lost growth this quarter, but in our opinion, the environment is very stimulatory. Interest rates are very low, and governments are spending money.
What does that mean for investing?
It means investors should at least consider the prospect of inflation being higher in the years ahead, and we think that the best way to protect a portfolio is by getting an inflation-linked cash flow. However, that needs to be bought at a reasonable valuation. Inflation-linked bonds are one way to do that, but a ten-year inflation-linked bond is yielding negative 0.8 per cent at the moment3.
Shorter-term fixed income instruments with floating rates could be attractive for a portfolio if interest rates are expected to rise but yields are pretty skinny in these markets at the moment. As inflation increases, investors should benefit from a floating rate on their portfolio if interest rates are able to rise. An alternate is for an investor to consider equities.
In our opinion, Aussie equities are providing very strong free cash flow and margins are strong in most industries as we move higher into fresh index highs. As a result, we expect investors could get a high dividend income from the market at the moment. In fact, in July we have set a 5.7% distribution target for our Equity Income Generator Fund, which will be paid out in level monthly instalments this financial year4. We believe this provides a good reward for investors and is well above inflation or yields available on most asset classes. There is capital volatility which means prices of shares do fluctuate, but in general, as you can see from the chart below Australian equities have been able to generate an income of around 5%, and in all but two of the five-year periods since the 1980s have made capital gains too5. In our opinion, this is a strong argument for patient long-term investing and sticking to a plan.
We are coming off a decade where inflation has been quite low globally, so companies have been able to take advantage of the low interest rates designed to boost the economy. Where companies have been able to increase their selling prices at the same rate, (or ideally a higher rate) than their cost price, this is generally considered to be a positive factor for that company’s share price. We believe that quality companies that have price-making abilities, as opposed to price taking, in an inflationary environment, should be able to increase profit margins.
If a company can push up the prices of its goods and services as costs rise, it potentially can increase its margins. We believe these types of companies would be attractive businesses to invest in. Cyclical sectors like mining can enjoy such periods in the cycle where commodity prices shoot up well in advance of costs, and create great wealth for investors. The battery minerals space is a very good contemporary example, as it has experienced a quick boom after some businesses in the sector, such as lithium miner Altura, went bust in 20206. Others were sailing close to the wind before things turned up in this boom7,8.
Of course, the converse is also true when a company’s costs rise more than its revenues, it can face a profit squeeze. We saw this phenomenon in action in Australia’s mining services sector earlier this year in February’s reporting season. Many contracts in this sector had become fixed price and the huge boom in mining has driven up wages in that sector in a dramatic fashion, putting a hard squeeze on its profit margins. Some companies have been squeezed, while others have negotiated for staff retention or wage increases to be footed by the now very profitable miners. This scenario is a good example of the hard discussions cost-push inflation can bring9.
The current earnings season is showing that profits have risen quickly, and we are seeing strong earnings upgrades coming through10. But that might not last if inflation does flow through the economy.
Companies with growing dividends become more attractive because payouts are likely to rise as inflation increases, particularly if the business is a price maker. At the moment, we believe dividend-focused portfolios are attractive. Over time that will allow income to grow along with the pace of inflation. And hopefully, an investor will get capital appreciation as well.
Price-makers are generally companies with strong moats. A good example at the moment is health care, and particularly the pathology sector of the market. There is big demand for health services and it’s taking a larger share of wallet in the economy.
Pathology players are experiencing increased costs, because there are a lot more collections going on as a result of COVID-19 testing. They are able to pass through higher prices and they operate on very strong margins in our opinion. They are also experiencing operating leverage from increased volumes going through their businesses.
We believe other asset classes, such as real estate and infrastructure, could also have direct links to the consumer price index, proving another attractive alternative for investors. For example, retail shopping mall leases are often linked to inflation.
In infrastructure, regulated returns are sometimes based on a weighted-average cost of capital and they have inbuilt inflation hedges as well. We expect both real estate and infrastructure assets should continue to perform well, as long as inflation expectations don’t get too high as these sectors generally rely a high level of debt. As such, they won’t enjoy the costs of that debt needing to rise if inflation needs to get reined in by central banks.
If an investor believes inflation is a risk, and there’s plenty of evidence to support that proposition, then that should be built into a portfolio. Equities can provide a way of doing that.
3. Bloomberg. As at 10 August 2021.
4. Please see estimated distribution assumptions note at the end of this document.
5. AMP Capital, FactSet.
10. FactSet, AMP Capital.
Subscribe to SMSF using the form below to receive all of my articlesDermot Ryan, Co-Portfolio Manager (Income)
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