How to prepare for inflation

PORTFOLIO POINT: Looming inflation means you might need to adjust your portfolio in terms of shares, property, bonds '¦ even debt.

“The Greeks gave us democracy, but their greatest contribution to government was watered-down money,” according to The Bear Book author John Rothchild. He and other financial historians tell a disturbing history of indebted governments debasing their currency and printing money to avoid raising taxes or cutting spending.

So it is interesting here we are again with Greek finances in the news and concern about inflation on the horizon.

If you believe that history repeats itself after each generation forgets the past then we have lived long enough to be surprised by the next outbreak of inflation. Alternatively, if you look for conspiracy behind every accident you will note that a favourable outcome of 1970s inflation was the halving of bloated Vietnam War debt relative to GDP.

Despite perhaps there being only a one in three chance high inflation is around the corner, it may pay to know the answer to the question: Which investments work best in inflation? Here I’ll try to answer that question.

Shares

While it is mythically held that shares are good inflation hedge, this is the case only over the medium and long term. This is only because a diversified portfolio makes enough money in the good non-inflationary times to more than cover for poor performance during inflationary periods, which is not the case for other asset classes such as cash and traditional bonds.

In the short term, however, companies can struggle to raise prices (or shrink package sizes) fast enough to keep up with rising wages and factory supplies. The tax system doesn’t adjust for inflation so company profits and capital gains are taxed more and depreciation and other allowances are worth less. Rising interest rates add to company costs and also cut consumer budgets, resulting in lower sales volumes.

Most importantly, the prices investors are willing to pay for shares can fall alongside overall optimism and as bond yields become more attractive. Looking back to the 1970s, the modest real performance of shares was driven more by falling price/earnings multiples than corporate earnings, which eventually caught up with inflation.

That said, not all companies perform similarly.

Better performers include energy and resource companies, because commodity prices rise while costs of their extraction remain unchanged. BHP, Woodside and Rio Tinto are just a few of the companies that will benefit, or are likely to. Gold and gold miners are also obvious inflation hedges. Soft commodities such as timber and agriculture should also perform, but unfortunately not if accessed via failed MIS investments.

Utilities and other infrastructure are also sought out for inflation protection because they enjoy CPI-linked revenue streams. However, one must select investments carefully: a developed toll road or water utility would be expected to perform better, clipping bigger tickets compared to a utility forced to buy coal or oil to fuel their generators at higher prices.

The bid for Transurban by Canadian pension funds is a sign some are taking the threat of inflation seriously (see Robert Gottliebsen's feature, Why I like Transurban). Unfortunately you can’t consider Telstra a reliable inflation hedge given uncertainty over its infrastructure assets.

Retailers with pricing power selling things we need to buy (consumer staples) should perform better than companies trying to tempt us to buy things we might be able to postpone when personal budgets tighten (consumer discretionary). In this regard you would select companies like Woolworths and Wesfarmers over Myer and David Jones.

Banks are expected to be losers in an inflationary environment because loans are repaid with money that is worth less and less each year. The collapse of the US savings and loan institutions in the late 1980s can be traced to American borrowers having locked in low interest rates prior to inflation breaking out. Of course in Australia it is impossible to get a 30-year loan and most borrowers take out variable-rate mortgages. That, along with the big four banks having demonstrated pricing power, means the situation may not be that bleak. Don’t expect manufacturers to perform well because their costs often rise faster than their prices do, and sales can fall.

Property

Commercial property tenants pay rent contractually linked to CPI, which means property trusts should enjoy inflation-adjusting revenue. A bout of inflation might be very welcome for those distressed investors in frozen property trusts because it should shore up falling commercial property prices and eroding high levels of indebtedness. This might accelerate the beginnings of a recovery in listed property trusts.

Residential property prices generally keep up with inflation. However, after several years of property price increases well in excess of the 120 year trend of prices rising by inflation plus 2%, further price growth and rental income may be constrained by stretched affordability.

Bonds

If you were a US investor you wouldn’t want to be lending your money to your government at 4.6% fixed for 30 years, despite that being 4.45% higher than the recent at-call rate of 0.15%. While an extreme comparison, this is the dilemma facing Australian savers choosing between high-yield at-call rates and locking up their money for five years to earn an additional 1%.

During the surprise run-up in inflation to the peak rate in 1975, traditional medium-duration and long-term bonds underperformed. However, once the inflation cycle peaked and interest rates came down, these locked in investments outperformed.

So the general rule of thumb is:

• In a rising inflationary and interest-rate environment, avoid bonds and deposits with maturities of more than three to five years and favour cash, floating rate investments or inflation linked bonds.
• After inflation is broken and as interest rates fall, lock in longer-term fixed-term bonds.

A few things also to note:

• The bond market is professionally neurotic about rising interest rates and inflation, which means the greater return you get on a five-year, 10-year or longer-term bonds or deposit reflects their anxieties. What you need to be worried about is the market being wrong or central banks having another agenda, such as promoting financial system stability. Locally, the opposite may be occurring, where the RBA is using higher interest rates to slow property prices from bubbling over and banks are being forced to seek more local finance.
• Floating rate bonds, which yield a margin over a benchmark interest rate, offer some protection against rising inflation. However, as in the US and Europe today, and Australia only a year ago, benchmark rates can be held down while inflation continues on. In the 1970s, CPI outpaced interest rates for several years.
• The capital value of hybrid income securities fluctuate a lot more than any extra premium they offer. If your invested company doesn’t perform well in an inflationary environment, then you might suffer greater capital loss than any extra yield you get.
• Inflation-linked bonds are a nice complement to interest rate-linked bonds. Aside from short-term repricing by bond traders, your investment is not linked to interest rates. They are generally structured so that your capital appreciates with CPI and your ongoing interest is paid as a fixed percentage of that adjusting amount. At the moment bonds from NSW Treasury are paying about 3.2% return above inflation, which is a total return of 6.2% if CPI is 3%.

More debt anyone?

If you are quite certain that paper money will be worth much less in the future, then you should borrow it from others now. Your real liability will decline as inflation erodes your debt. Provided you invest in inflation-fighting assets and lock in your interest rate then you could be well ahead. American Dan Amerman, who spent years keeping failed S&L institutions on life support, is a proponent of this strategy.

However, this works better in the US where you can borrow for less, fix your interest rate for up to 30 years and even refinance if you’re wrong and rates fall. All these strategies are difficult to implement locally, but can be done if you are keen on buying property in the US (or for that matter the many other places in the world where you can borrow at a 2–3% interest rate and earn rental income of 4–6%).

Currency

Inflation and currency crisis go hand in hand. This suggests one needs to a have a firm view whether the Australian dollar will strengthen further or weaken relative to other countries. On balance one might expect the Australian dollar to stay strong or strengthen further in a high inflationary environment for three reasons: demand for Australian commodities, higher interest rates and concerns about the strength of US, UK and Euro currencies. If correct then your investments offshore should be currency hedged and maybe you should buy more of them while the dollar is strong.

INFLATION ETF™¢

Exchange Traded Funds (ETFs) are all the rage now, so why don’t we translate this portfolio thinking into a fictitious inflation fighting fund. We’ll even trademark the attractive name “INFLATION” to describe it. Like most ETFs this will need to be constructed from various indices so market makers can do their job to keep asset and security prices aligned. However, you may be able to implement this using the example securities or funds noted. Since investing in indices may be too broad, there may be an argument to carefully filter investments by their inflation-fighting characteristics, suggesting the need for a managed fund instead. In the interests of simplicity, we’ll leave out more complex methods such as gearing and shorting poor inflation hedges.

The following table summarises the construction of our INFLATION ETF™¢.

Time will tell if inflation proves a big problem and whether our attempt at building a benchmark inflation fighting portfolio does an adequate job protecting the value of your assets from its ravaging. It’s important to note that if commodity prices are actually overcooked then this approach may do exactly the opposite.

However, having had so many outbreaks of inflation to study in the past, we can assume that many of the successful techniques that prevented wealth erosion in the past will continue to be useful in the future.

Doug Turek is the managing director and principal adviser of independent money management and wealth advisory firm Professional Wealth. The range of investments cited here is for illustrative purposes only and should not be considered recommendations by the author.