Inflation’s ‘team transitory’ is a shrinking breed. Ever since huge stimulus packages were announced in 2020, and the effects of supply chain issues became clear, central bank inflation predictions have consistently undershot reality – and that was before Russia’s war on Ukraine and all it entails.
In February 2021, for example, Federal Reserve chair Jerome Powell said that it could take three years for the US to reach its 2 per cent inflation goal. Further back, in late 2020, the Fed had suggested it would not raise rates until the end of 2023. But US inflation had hit 7 per cent by December 2021 and the Fed raised rates last month, with officials hinting that six more rises could take place this year.
Last August, meanwhile, the Bank of England forecast the UK consumer price index would peak at 4 per cent in 2022. By the end of last year it had already hit 5.1 per cent. The Bank now anticipates that inflation will hit 8 per cent in June – exacerbated by Russia’s invasion of Ukraine, which has caused an energy supply shock and put further pressure on global supply chains. No one knows how price growth will play out, but in the near term it poses a significant threat to the value of your savings.
If inflation does continue to prove persistent, the simple truth is that no asset is guaranteed to protect you. However, research suggests that so-called ‘real assets’ – assets underpinned by physical material – have a better track record of holding their value in times of high inflation than many others.
The chart below shows average returns over the past 20 years for periods when the US consumer price index growth stood at over 2.5 per cent. 'High growth' represents a period where gross domestic product (GDP) was above 2.5 per cent, with 'low growth' the opposite. “The key takeaway here is that real assets outperform traditional asset classes during high inflation environments,” BlackRock says.
But real assets are a broad church: from commodities to property to infrastructure and even luxury items, all of these assets have different price drivers. And associated equities, such as mining, energy and housebuilding companies, can be as susceptible as any other company to idiosyncratic issues and changes in overall market sentiment.
Even so, there are some rules of thumb to which attention should be paid. Inflation tends to rise either due to higher demand via stronger economic growth or because of a reduced or constrained supply of goods (eg energy and food) leading to higher prices in the inflation basket – the latter being the current driving force. “In both scenarios, commodity prices tend to rise,” says Mick Gilligan, head of managed portfolio services at Killik and Co. He adds that infrastructure and real estate also tend to rise in value, “often due to explicit inflation-linked contracts that the infrastructure provider or landlord has with the infrastructure user or tenant”. On top of this, the replacement cost of the physical assets increases as input costs (such as building materials and labour) rise.
Commodities
Commodity prices should provide inflation protection where they are the source of price rises. For example, much of the inflation conversation in 2022 has focused on energy prices, given Russia is the world’s second-largest producer of natural gas and third-largest oil exporter. The Wisdom Tree Brent Crude Oil ETF (BRNT) is up 49 per cent and the Wisdom Tree Natural Gas ETF (NGAS) is 58 per cent higher in the first three months of 2022. Shell (SHEL) and BP (BP.) have returned 28 per cent and 16 per cent, respectively, over the period.
But although exchange traded commodities can give you exposure to commodity price movements via derivatives, Laith Khalaf, head of investment analysis at AJ Bell, cautions most retail investors to steer clear of these products as their pricing mechanisms are complex, and they have charges that won’t be immediately apparent. “A better way to invest is via a diversified portfolio of commodity-producing companies, such as BlackRock World Mining Trust (BRWM) for metals, or the iShares S&P 500 Energy Sector UCITS ETF (IUEF) for fuels,” he says.
The price of some agricultural goods has also shot up. Soft red wheat, for example, is up 50 per cent this year, according to FactSet data – Ukraine is a large wheat exporter with a 10 per cent share of the global market in 2021. The country is also one of the world’s top exporters of barley and sunflower seeds, meaning the price of these products has surged this year, too. Agriculture-focused funds – such as the iShares Agribusiness UCITS ETF (SPAG) – can provide some hedge to rising food prices, and the ETF is up 23 per cent since the start of the year.
Other commodities – such as precious metals – have provided a less reliable inflation hedge and can be very volatile. Gold, however, can be thought of as a speculative inflation hedge, although Khalaf refers to it as a “hedge against catastrophe, rather than inflation specifically”. As this implies, its recent rise has more to do with the war itself than the knock-on effect on prices.
As with most precious metals and other commodities, the gold price tends to be volatile and is currently at an historic high. Rising interest rates won't help gold either, because higher rates increase the relative attractiveness of cash and bonds as safe havens. However gold is a good diversifier, so “it might be worth having a little bit in your back pocket just to own something that will behave differently to the other assets in your portfolio”, Khalaf says. Investors can get low-cost, convenient exposure to physical gold through the likes of the Invesco Physical Gold ETC (SGLP).
Infrastructure
Infrastructure assets can be accessed via closed- or open-ended funds, the former having the advantage of being able to own assets that are not very liquid without having to sell them when investors want their money back.
Several infrastructure trusts disclose an ‘inflation delta’, an estimation of the sensitivity of their net asset value to the inflation rate. HICL Infrastructure (HICL) estimates its inflation delta to be 0.8. “If inflation turns out to be 1 per cent per annum higher than HICL’s base assumption, in every future forecast period, the expected return from the portfolio would increase by 0.8 per cent,” Gilligan says, adding that the equivalent number for International Public Partners (INPP) is 0.78. “I like both trusts as well as 3i Infrastructure (3IN),” he says.
The inflation sensitivity for renewable energy infrastructure investment trusts is less strong. Research conducted by Numis Securities last year found that the average inflation linkage for energy generation renewable infrastructure trusts was 60 per cent, falling to 25 per cent for energy efficiency trusts and 5 per cent for energy storage trusts.
While the core infrastructure trusts have the strongest inflation linkage, they also have long-term contractual obligations that act in a similar way to a long-term fixed-income asset. That means they are exposed to interest rate risk, says Edward Park, chief investment officer at Brooks Macdonald. “Should inflation cause central banks to raise interest rates, and more importantly cause the bond market to price in higher interest rates over time, markets will pay less for infrastructure assets even if the cash flows are partially inflation-linked,” he says.
Property
Property has historically provided some inflation protection because, as prices rise, rental income tends to follow, in turn pushing up asset valuations. As the IC’s Alex Newman noted in February, Cushman & Wakefield, the real estate services group, found that every one percentage point increase in inflation between 2003 and 2021 was associated with a 1.1 per cent increase in total returns earned in private real estate, and a 4.5 per cent increase for publicly listed real estate investment trusts (Reits), despite higher levels of volatility in the latter.
However, that analysis was focused on US markets, and inflation linkage will vary across Reits. Daniel Lockyer, senior fund manager at Hawksmoor Investment Management, notes that those exposed to retail properties are unlikely to be able to increase rents as much as those that own industrial assets. By contrast, some of the Reits holding industrial assets with inflation-linked rent reviews are in very high demand – such as Tritax Big Box Reit (BBOX) and Urban Logistics Reit (SHED) – which were both trading on a premium to net assets of 27 per cent on 28 March.
Khalaf likes TR Property Trust (TRY), which has a market capitalisation of £1.4bn and traded at a 6 per cent discount to assets on 28 March. The company invests in both listed and physical property, and looks well-placed to weather inflation given its exposure to the European real estate market where the use of long-term, indexed leases is widespread.
Reits tend to use a combination of indexed-linked (CPI or RPI) rent uplifts, fixed uplifts and open-market rent reviews. “Indexation should do well to provide real rental growth over the medium to long term (in line with the typical investors’ investment horizon) and provide downside protection in a moderately inflationary environment,” says Shayan Ratnasingam, research analyst at Winterflood securities. “However, if inflation overshoots then open-market rents will do better in capturing above-trend inflation”.
Real assets in your portfolio
All of the above assets will typically be held as part of a diversified portfolio, which raises the question of what kind of weighting should be afforded. The most conservative strategy in Killik & Co’s Managed Portfolio Service has around 30 per cent exposure to inflation-linked assets such as real estate, infrastructure, commodities, and inflation-linked bonds. But higher-risk portfolios have a lower allocation to these assets.
Khalaf says that if you want to have a diversified multi-asset portfolio, “we’re probably talking about 10 to 20 per cent of your overall wealth” exposed to real assets. Remember if you own your property, your exposure to this asset is likely to already be a significant proportion of your wealth.
Professional weightings to such assets are sometimes governed by industry rules. Lockyer says around 20 per cent of Hawksmoor’s Vanbrugh Fund (GB00BJ4GVQ92) (designed for the average-risk investor) is in ‘real’ assets, compared with 30 per cent of the Hawksmoor Distribution Fund (GB00BJ4GVL48). “The reason for the difference is purely due to respective mandates, as Vanbrugh sits in the Investment Association Mixed Investment 20-60% Shares Sector and needs to have at least 30 per cent in fixed income and/or cash. Distribution doesn’t have that constraint as it is in the 40-85% Shares sector, so can have more alternatives to bonds,” he explains.
Park thinks that arguably one of the best ‘real assets’ to protect against inflation is equities, particularly companies with strong brands that are able to pass on inflationary pressures to their end consumers. “The latest fourth-quarter earnings from Amazon (US:AMZN), for example, contained a sizable hike in the cost of Amazon Prime membership, but few analysts felt the increase would lead to a spike in cancellations given the strength of the brand and the compelling value offering of the subscription,” Park says. “High-quality companies that are able to maintain their margins in the face of inflationary pressures are highly sought-after by investors during times of sustained inflationary pressures.”
