There are fears that inflation is picking up in developed countries, after many years of being very subdued. How might investors look to protect themselves against – and profit from – inflation?
By Hamlin Lovell
Index-linked government (or corporate) debt is perhaps the most obvious asset class. Typically, its principal will rise with reference to a specified price index, which raises the first issue – whether investors have confidence in the relevant measure of inflation. Most governments have an incentive to try and massage down inflation numbers, but this should not be possible where independent statistical agencies are in charge.
A bigger concern however may be the valuation of index linked bonds, which has been inflated, partly due to captive demand from pension funds that maybe more or less forced buyers”
A bigger concern however may be the valuation of index linked bonds, which has been inflated, partly due to captive demand from pension funds that maybe more or less forced buyers. UK linkers, for instance, trade well above par value and have negative real yields. Linkers are not a pure play bet on inflation, because their coupon yields are generally fixed. Some issues of linkers might be more sensitive to interest rates than to inflation. In particular, as linkers tend to have long maturities, their rate sensitivity can overwhelm the impact of short term changes in inflation.
Corporate index-linked debt offers an additional credit spread. Both government and corporate index-linked debt can be less liquid than nominal issues, so in a liquidity-driven selloff they may be harder hit than nominal debt, partly as margin rates/haircuts can be higher in the first place and might be more susceptible to being jacked up by brokers.
Inflation linked issues in emerging markets, such as Brazil, may have much higher real yields for those who can take on the currency risk. It may even be possible to pick up some additional yield, after the costs of hedging back to hard currencies, though currency hedging involves various costs, risks and uncertainties.
Sitting on cash is perhaps the simplest strategy, which did, perhaps surprisingly, provide a high degree of protection during some historical episodes of inflation”
Sitting on cash is perhaps the simplest strategy, which did, perhaps surprisingly, provide a high degree of protection during some historical episodes of inflation, at least in the UK and US. This was because central bank policy rates loosely followed inflation higher for many years, maintaining positive real interest rates. However, since 2009, unconventional monetary policy has taken over, and real interest rates have been negative for many years. In the US, rates are only just starting to catch up with inflation. It remains to be seen whether any inflation shock will be met with sufficiently steep rate hikes, to return real interest rates to positive territory.
Floating rate debt
Similar arguments apply to instruments, such as senior secured loans, asset backed securities, mortgage debt, and associated structured credit, where the coupons are a spread over floating rate interest rates, typically interbank rates, (which are usually a bit above central bank policy rates). Historically, the income streams might have tracked inflation higher – but we cannot predict if that will be true in future.
For nearly all corporate credit – either fixed or floating rate – the principal element of returns will seldom follow inflation higher, as par values are nearly always fixed in nominal terms. Where a significant part of yield to maturity comes from amortising a discount to par, this fixed source of return is eroded in real terms under inflation. Worse still, much credit paper is actually trading at a premium over par values, so could be even more vulnerable.
For fixed rate credit, inflation should improve both cash flow coverage and debt-related ratios”
Other factors need to be weighed up when it comes to credit. For floating rate credit, higher interest rates might increase debt service costs – and therefore reduce cash-flow coverage ratios. On the other hand, inflation raises company revenues and profits whereas debt is nominally fixed, so debt coverage ratios could improve. For fixed rate credit, inflation should improve both cash flow coverage and debt-related ratios – but then again higher interest rates could have some adverse impact on valuation of fixed rate high yield bonds.
Equities are real assets so company revenues should in most cases rise with inflation, but valuations might contract if inflation leads to higher interest rates – and therefore raises discount rates used for valuation. Both the Bernanke taper tantrum in 2013, and the early February 2018 selloff, suggest that equities will be sensitive to higher rates. During these panic sell-offs most equities fall in a synchronised way but over longer periods of inflation, investors will start to discriminate between those companies that have the pricing power to pass on cost increases, and those that do not. It is perhaps an uncomfortable truth that companies operating in the so-called “sin” sectors – including tobacco, alcohol, gambling and pornography – are believed to have stronger pricing power.
Over longer periods of inflation, investors will start to discriminate between those companies that have the pricing power to pass on cost increases, and those that do not”
Ironically, commodity producers are the classic example of a price-taking industry without pricing power at the company level – but they may not need it if their markets are on fire.
Commodities, and particularly precious metals, are thought to be one of the best inflation hedges, based partly on the 1970s experience. Commodities can be accessed through futures, ETFs, plain vanilla indices and a growing variety of more sophisticated indices that aim to add value through features such as optimising roll yields, or rebalancing allocations according to rules such as mean reversion. CTAs (Commodity Trading Advisors), also known as managed futures funds, can have significant exposure to commodities, but it varies a lot between managers.
Commodity equities should, in theory, offer a leveraged bet on commodity prices since the companies will always have operational leverage and may also have financial leverage. However, if inflation is associated with an equity rout, commodity equities can have a nasty habit of dancing to the equity tune – and becoming more correlated with equities than they are with commodities.
if inflation is associated with an equity rout, commodity equities can have a nasty habit of dancing to the equity tune
Real estate and infrastructure
Real estate and infrastructure are also seen as inflation hedges, as both capital values, and rental or concession income, can show close relationships with inflation. In both cases, valuations could also be threatened if faster inflation occasions higher interest rates. Infrastructure also faces political risk, seen most recently in the UK Labour Party’s threat to renationalise some private infrastructure projects.
Growth-flation or Stag-flation ?
Inflation comes in different flavours. The combination of higher inflation and steady economic growth, equating to higher nominal economic growth, is likely to be most benign for equities, credit and infrastructure. It is stagflation – defined as sluggish growth, or even recession – in conjunction with inflation that can be the worst climate for investing, leaving far fewer places to hide.