Invest to beat inflation

Colin Low, managing director of Kingsfleet Wealth, says: "I think inflation will go up further – it wouldn't take much for it to start to run away, which means we would see more regular increases in interest rates. You don't want an inflation shock hitting your portfolio, so building in some inflation protection before that happens is prudent."

And you should not just consider what level CPI inflation is at, as this is a national average. Tilney Group has found that over the last 20 years the wealthiest 10 per cent of UK households, defined as those earning more than £78,500 a year, were hardest hit by inflation, experiencing a rate of 64 per cent. This compares with 50.7 per cent for the typical income household earning around £30,000 a year.

"Everybody's rate of inflation is going to depend on their individual spending basket," explains Jason Hollands, managing director at Tilney Group. "Some of the areas that have inflated the most include private school fees and holidays, which means higher income families may need their portfolios to deliver much more above the Bank of England's inflation target of 2 per cent."

Assets vulnerable to rising inflation

Cash

According to MoneyFacts, the best variable cash individual savings account (Isa) rate is the 1.07 per cent offered by the Post Office online Isa. With savings rates so low, investors need to make sure they are not holding too much cash as it is losing value in real terms.

"Inflation is the biggest enemy of cash savers," says Patrick Connolly, certified financial planner at Chase de Vere. "[But] everybody should hold some cash as an emergency fund to cater for any short-term requirements."

You should hold cash worth about about three to six months of your monthly outgoings. But many investors make the mistake of holding much more, often because they are worried about high market valuations or are just naturally more cautious.

Mr Hollands recently reviewed a portfolio where an investor was holding several hundreds of thousands of pounds in cash and had been doing so since 2007.

"This investor had no dependents and there was absolutely no reason for her not to put that money to work," he says. "We are in a world of relative value and that's a struggle that people have been grappling with for some years. Investors could have taken the view that everything is too expensive [to want to invest] as that lady did, but effectively you would have lost capital in real terms."

Cautious investors or those concerned about high valuations could drip feed money into the market, suggests Rob Morgan, pensions and investment analyst at Charles Stanley. If you invest set amounts of money once a month, market fluctuations allow you to benefit from pound cost averaging. When markets go up and are more expensive your set amount of money will buy fewer units or shares, and when markets fall and are cheaper your set amount will buy more.

Fixed income

Fixed income assets such as government bonds (gilts) pay the same level of interest whether inflation is rising or falling. So if inflation rises the purchasing power or real value of the interest payments, and the fixed capital repayment at the maturity of the bond will fall.

"Traditionally, investors bought fixed income for two reasons, as a source of income and because it was not too volatile," says Mr Hollands. "But now yields are low so you could incur future losses if you buy a bond trading above its maturity value. The upside on fixed income assets is limited, and therefore what it comes down to is whether the yield is attractive. But with yields in large part below 3 per cent – particularly in the gilt market – why hold an investment that you're going to lose money on in real terms? These are return-free sources of risk - not risk-free sources of return."

Mr Morgan adds: "Be wary of fixed income. We had a mini sell-off in gilts recently and yields went up a bit [as prices fell]. That's an indication of what could happen in bond markets if interest rates and inflation surprise on the upside."

In this situation, assets such as corporate bonds and equities with so-called bond proxy characteristics could also suffer as investors move away from them to areas offering higher returns.

Mr Low suggests you review your fixed income exposure. He has cut the fixed income allocation for clients with balanced portfolios to 10 per cent, down from 20 per cent last year and 30 per cent two years ago. But he likes GAM Star Credit Opportunities (IE00BYZXFP13), a fund that tends to invest in short duration fixed income assets that are less exposed to interest rate increases.

Index-linked bonds, where both the income and maturity values are adjusted in line with inflation, should do well in an inflationary environment.

"However, in the short term the performance of inflation-linked bonds is likely to be determined by general sentiment towards inflation and often investors are willing to pay a premium for inflation protection," says Mr Connolly. "So the value of these bonds has already risen significantly and they now look very expensive."

He does not include these assets in client portfolios.

Investments for beating inflation

If your portfolio is well diversified across a number of assets, sectors and geographies it can help to mitigate the effects of inflation.

"Make sure your portfolio includes some areas that may benefit from or be resilient to interest rate rises," says Mr Morgan. "Younger people who are a long way from retirement can have less diversified portfolios and be more focused on risk and growth assets, but if you're approaching retirement your portfolio needs to be prepared for different situations."

You also need to hold assets that have the ability to outpace inflation or have some inflation protection built into them. 

Equities

Equities are a powerful way to hedge against inflation because good companies have the potential to increase profits at least in line with inflation. For example, the FTSE 100's yield of 3.85 per cent is above inflation. "Equities should be a key part of investor portfolios – even a cautious portfolio should have a good 40 per cent in equities," says Mr Hollands. 

He suggests focusing on companies with healthy free cash generation that can pass on their returns to shareholders via dividends or by reinvesting cash in the business for growth.

"What you want are companies that can grow their profits and dividends in the face of inflation," adds Mr Morgan. "These would be companies that have pricing power and the ability to pass on cost increases they are experiencing themselves to their customers." 

Examples of funds focused on companies with pricing power include Liontrust Special Situations (GB00B57H4F11).

UK and global equity income funds can also help to beat inflation, especially if the yield on these funds is higher than the rate of inflation. Investors often only hold equity income funds that take a defensive approach but more cyclically positioned income funds can improve diversification, for example, JO Hambro UK Equity Income (GB00B95FCK64) and Standard Life Equity Income Trust (SLET).

Alternative assets

If you are looking to reduce your fixed income exposure you could consider absolute return funds. Their objectives often include beating inflation and making positive returns regardless of market conditions – although this is not guaranteed.

"You have to be clear about how each absolute return fund works because they are run differently to each other," says Mr Low. "We like ones such as Jupiter Absolute Return (GB00B6Q84T67) that use hedging strategies and so can make money from a falling market or falling stocks. We also like ones such as Pyrford Global Total Return (IE00BZ0CQJ19) which use tactical arrangements to drive returns by moving in and out of assets if they think there's an opportunity."

Infrastructure and renewable energy investment trusts often invest in long-term projects that derive some of their income from government with an inflation-link, meaning that if inflation rises their income will too. But many infrastructure investment trusts are trading on high premiums to net asset value.

Commodities such as gold can help to beat inflation so Tilney Group has an allocation of around 5 per cent to physical gold in many of its client portfolios.

"Gold is perceived to be a store of value," says Mr Hollands. "You can't simply go and print more gold so it is a potential hedge against money printing." 

He favours getting exposure to this asset via a physically replicating exchange traded fund (ETF) such as ETFS Physical Gold (PHGP).

Physical assets such as property can also help to generate a real return. With commercial property, investors can benefit from upward rent increases and some of the contracts may have some inflation linkage.

"We use commercial property in client portfolios," says Mr Connolly. "This can provide a steady income stream and additional diversification. However, this asset isn't without risk, especially as the performance of commercial property is often correlated to that of the economy as a whole."

So with Brexit on the horizon there could be a negative impact on some areas of the UK property market.

Overseas assets

The course of UK inflation is likely to be heavily influenced by the terms of this country's withdrawl from the EU, so holding some overseas assets could be beneficial.

"If we have another substantial fall in the pound you'd expect inflation to remain high," explains Mr Morgan. "If we get a more business friendly Brexit with a phased in withdrawl that businesses could cope with and adapt to it, then the pound could rally and inflationary pressures may dissipate quite rapidly. But if we get a disappointing Brexit, you really want to be holding some overseas assets as they will help you maintain a relatively stable portfolio [even if your UK exposure is hit]."

Cautious portfolio allocation