Isa season is upon us - but with consumer price index (CPI) inflation hitting 4 per cent and the UK's economy contracting by more than previously thought in the final quarter of 2010, you might be wondering where to put your money. "Stagflation" - high inflation accompanied by slow economic growth and high unemployment - is a worrying prospect. After all, inflation is the mortal enemy of fixed income, while shares are unlikely to make much progress if the economy's in the doldrums.
Raise the risk level
Placing your investments within an individual savings account (Isa) wrapper does at least lessen the impact of taxation. But at current inflation rates, even without a tax hit, your Isa still needs to be earning 4 per cent-plus for your money to simply maintain its real value. This means you might need to take on a bit more risk - especially as UK investments may not provide the growth you need
Look at incresaing your Isa's exposure to assets that benefit from inflation but are less influenced by slower economic growth in western economies. "Emerging markets are becoming expensive so stocks which benefit from them but are not at greatly inflated prices are a good option," says Ana Armstrong, chairman of Distinction Asset Management.
Luxury good brands, as well as shares with global and emerging markets exposure are also contained in some Europe ex-UK funds and investment trusts (see ). The (which we tipped in the 11 February edition) and db x-trackers MSCI World Consumer Staples TRN Index ETF, which tap into global consumption plays, will also give you some of this exposure.
Global water and utility companies often yield more than inflation and 50 per cent more than the MSCI World index, but trade at large discounts on price-to-book value versus the broader market. You can get exposure to these via low-cost exchange-traded funds (ETFs) such as iShares S&P Global Water. Infrastructure investments often have their revenues linked to inflation, and globally-focused funds include the First State Global Listed Infrastructure Fund.
Other sectors with utility-like characteristics include telecoms, while tobacco shares have a great record of dividend increases and also offer emerging-market exposure. Such shares form the bedrock of many income funds. Artemis Income has recently shifted it focus towards to defensive investments such as tobacco and pharmaceuticals rather than growth plays, as these tend to be better positioned to withstand a difficult economic environment. People don't stop smoking or taking medication just because the economic situation has deteriorated. Lower-cost exposure to defensive investments can be attained via an investment trust such as the Edinburgh Investment Trust or an ETF such as the iShares FTSE UK Dividend Plus ETF.
A strategic fund such as Artemis Strategic Assets, which has a wide investment brief, could also be a good option. "This allows it to capitalise wherever the economic situation is going," explains Danny Cox, head of advice at Hargreaves Lansdown.
Part of the reason that inflation is high in the UK at the same time as growth is slow is because global commodity prices, driven by emerging markets demand, are high. "Commodity funds have a place in your portfolio but treat them with caution as your emerging markets funds are also a commodity play, and you will have a bumpy ride,"says Mr Cox.
Given these concerns, Adrian Lowcock, senior investment adviser at Bestinvest, suggests the Investec Enhanced Natural Resources Fund, which includes an element of downside protection as can take bets on falling prices (short sells), which should make it less volatile than a broader commodity index.
A number of multi-asset real return funds are benchmarked against inflation and aim for positive returns, the Cazenove Multi-Manager Diversity Fund being one example.
Betting on bonds
Given that the interest (coupon) on a bond is fixed, these vehicles are particularly vulnerable to the threat of inflation. However, for investors who don't have a long-term time horizon, these remain a mainstay investment. Index-linked bonds seem like the obvious option, but high demand from UK pension schemes has kept the price of UK index-linked gilts prohibitively high.
An alternative is a global index-linked fund which diversifies inflation risk across markets, reducing country risk and improving the prospect of a higher yield such as M&G Inflation Linked Corporate Bond or the iShares Barclays Capital Global Inflation-Linked Bond ETF.
Strategic bond funds, meanwhile, have the flexibility to allocate investment across the bond spectrum depending on the view the fund manager takes. These funds can also use derivatives for extra protection. Options include L&G Dynamic, Fidelity Strategic Bond, Artemis Strategic Bond, Henderson Strategic Bond, Invesco Perpetual Monthly Income Plus and M&G Optimal Income. The downside to these funds, though, is that their risk profile changes continually which makes them unsuitable for very cautious investors.