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OPINION

Profiting from inflation

Profiting from inflation
July 22, 2021
Profiting from inflation

Where inflation stands in the UK is clear enough. As the chart shows, in June the consumer price index (CPI) was 2.4 per cent higher than a year ago. On the one hand, that’s little to worry about since it is not far above the 2 per cent upper boundary beyond which inflation should not stray, according to the Bank of England’s remit. On the other, that’s quite an acceleration from nominal levels of just a few months ago and the assumption is that the official data lags the reality of rising costs that confront consumers.

 

 

Besides, what’s happening in the US might be more instructive since the US is supposed to be further down the track towards recovery from Covid-19’s worst economic effects. US consumer prices rose 5.4 per cent in the year to June, the highest rate since July 2008. The difference between now and then is that in mid 2008 the US economy was heading into the hole exposed by the sub-prime mortgage crisis and, one year on from the collapse of Lehman Brothers, US inflation was negative for eight months in 2009.

This time round the scenario is different. True, the uncertainties surrounding Covid-19’s path and the response to it may still be underestimated, and that might particularly apply to the US since pro or anti-vaxing is becoming as powerful a politico-cultural symbol as wearing a face mask (or not) or taking the knee. Even so, the assumption is that more ‘normality’ is on the way, which means more of the things that accompany recovery, of which inflation is often one.

That need not worry equity investors since equities offer a natural hedge against inflation. That’s the conventional wisdom. The truth is more nuanced. In a nutshell, it depends on what’s in your equity portfolio. Put very simply, rising inflation may be bad for growth-orientated portfolios, but – at least comparatively – good for value-style, income funds.

The logic behind bearish for growth is clear enough. Rising inflation invites a response from central banks, which – in one way or another – always involves more expensive money. Since a higher cost of money will dampen economic growth then it is likely to do the same to companies in the vanguard of such growth.

That it should be good for value stocks is more tenuous. Here the argument is that the companies behind these stocks tend to generate comparatively good cash flows, which should stand them in good stead when they face inflation’s effects. Possibly true, yet there is no escaping the point that, if rising inflation means higher interest rates, future cash flows will be discounted to present value using higher rates, which can only mean less value. Besides, value stocks – almost by definition – operate in low-growth industries so are more likely than growth stocks to struggle with whatever economic slings and arrows fortune hurls at them.

Nevertheless, when investment-data provider MSCI crunched some numbers about the effects of inflation on US equities it did, indeed, find that strong performance of high-yield stocks correlated well with rising inflation, while growth stocks had a low correlation (ie, they tended to perform badly). Other characteristics that investors might want in their portfolios to combat inflation are good earnings quality (ie, reliability), mid-cap stocks (FTSE 250 or thereabouts) as well as big-caps. What they don’t want – besides growth – is high beta stocks, whose volatility is implicitly tied to inflation as much as it is tied to their underlying equity market, and high leverage (debt to equity or to cash flows) even though debt’s fixed costs may become less onerous as inflation rises.

MSCI dug a little deeper, probing the effects of leading and lagging inflation indicators. As the chart also shows, not all inflation is equal. Some is consistently more volatile than other sorts. Especially volatile – and a leading indicator of general retail inflation – is inflation in petrol and oil (just as rising commodity prices are a leading indicator of wholesale-price inflation). In contrast, food-price inflation is a lagging indicator, as a close look at the chart shows. Indeed, petrol and oil inflation in the UK is currently on the high side of 20 per cent and therefore driving the rise in the CPI. Food prices, on average, are still lower than a year ago, according to official data (and hard though it may be to believe). Yet over the coming months this will change as processors and retailers pass on their higher costs.

These features are reflected in the performance of some sectors. Again, using US sectors versus various measure of US inflation, MSCI found that the performance of engineering sectors, oil and gas production and (surprisingly) consumer durables correlated closely with inflation’s changes. Sectors linked to discretionary spending had a looser link, with media, airlines and consumer services all tending to be especially weak if inflation was rising.

In practice, these findings can inform the composition of investors’ portfolios. Hindsight tells us it would have been nice to have had exposure to mining and oil in our portfolios these past few months. For example, in the Bearbull Income Fund, the 40 per cent gain in the value of its holding in diversified miner Anglo American (AAL) accounts for almost a fifth of the whole fund’s increase in value in the first half of 2021. Or it might be equally nice to have exposure to, say, food processors and retailers for when their time comes to pass on their higher input costs.

This is where exchange-traded funds (ETFs) enter the equation and demonstrate their merits. Holdings in commodity or sectoral ETFs can be used as hedging tools in the absence of specific stocks. Assume no holding in Anglo American and too much exposure to sectors vulnerable to rising inflation and the Bearbull fund might have compensated with a holding in, say, WisdomTree Brent Crude (BRNT) or perhaps WisdomTree Industrial Metals (AIGI). The Brent crude fund would have done a brilliant job, up 53 per cent in the first six months of 2021. Even the industrial-metals fund would have performed acceptably, up 16 per cent in the six months though 41 per cent on the year.

Meanwhile, with an eye on the sectoral inflation likely to come – and assuming no holdings in food processors or retailers – switching into WisdomTree Agriculture (AGAP) might still be a sensible move. This fund also had an acceptable first half (up 19 per cent) and is up 40 per cent on the year, but its poor five-year performance (down 5 per cent) implies there may be more upside in the event that food companies begin to pass on their higher costs. For UK investors, this ETF also offers the convenience of being denominated in sterling, whereas the BRNT and AIGI funds are only dollar-denominated. Some investors might like the opportunities that brings; others won’t like the risks.

None of this is a recommendation for these funds in particular. Rather, it is a comment that WisdomTree focuses on commodity funds and has an accessible website. But the important point is the generic one – that using exchange-traded funds as a means of hedging risk, or even to enhance returns, is a basic tool of portfolio management that every investor should actively consider.

 

●  Congratulations to the House of Lords Economic Affairs Committee for pointing out the bleedin’ obvious – that the Bank of England’s cavalier use of quantitative easing enriched their pals in the City, but shows little sign of having done good elsewhere in the economy.

Quantitative easing (QE) – for the few who still don’t know – is what happens when a central bank prints money specifically to lower interest rates and/or inject liquidity into an economy. The Bank of England’s special tweak on QE was that it would only issue money to buy new government debt and, in doing so, would somehow preserve the fiction that the bank was only exercising monetary policy, which is its remit, and not straying into government fiscal policy, which would be political and therefore unforgivable. Except, of course, that it did stray into fiscal policy as QE became the only tool in the bank’s box.

Sure, the censure of the Lords’ committee carries limited consequence and no defined penalties. And it’s probably no coincidence that the committee is keen to do a bit of virtue signalling because it is heaving with ex-City types; none more than Lord King who, as plain Mervyn King, was the bank’s governor when QE was launched way back in 2009.

However, the key question for those of us with capital to invest is this: which would be better for all, a £900bn programme of QE that will help bring us investment gains that, while unquantifiable, will be more than they would have been without it; the alternative would be for each of the UK’s 27.8m households to receive £3,200 in vouchers with the warning, spend it or lose it. The answer may depend on the extent to which each of us is community-minded and is willing to trust the common sense of others. That we got QE indicates how the elite would come down on the side of that moral dilemma and probably tells us why the rich get richer.

bearbull@ft.com