Inflation in the UK has been below the Bank of England's 2% target since the beginning of 2014. For a brief period last year it fell into negative territory, and even now it stands at only 0.5%, leading to ongoing concerns about deflation. However, the falling pound which will make imports more expensive is expected to push inflation higher. So what assets should investors consider buying to protect their portfolio in the event that inflation makes a comeback?
The received wisdom is that shares and real estate are good inflation hedges, while bonds especially long-term bonds tend to get hit by rising prices. But is this true? A comprehensive study of the effects of inflation asset prices was carried out by Elroy Dimson, Paul Marsh, and Mike Staunton of London Business School, and published in the Credit Suisse Global Investment Returns Yearbook in 2012.
Dimson, Marsh and Staunton looked at the relationship between inflation and real returns of several assets in 19 countries over 111 one-year periods, and concluded that reality doesn't always match up to expectations.
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For government bonds, the situation is straightforward. Dimson, Marsh and Staunton found that there is a strongly negative relationship between inflation and returns, with every one percentage point increase in inflation reducing real returns by 0.74 percentage points. This is relatively simple, since inflation erodes the value of both the principal and the individual interest payments.
Indeed, many governments deliberately use inflation as a strategy to reduce the real value of their national debt. Short-term bonds and deposits perform slightly better (though still badly) because the negative impact of inflation is likely to be cushioned by higher interest rates.
Shares also do badly, for several reasons. Equity returns come from both capital appreciation and dividend payments, and inflation erodes the value of the latter. Rising inflation means investors are also likely to expect interest rates to rise (meaning shares may become less attractive relative to cash). Lastly, higher inflation may mean lower profit margins if it feeds through into rising wages.
Bricks and mortar also perform worse than most investors expect, because the value of rental income, which forms a big part of real estate returns, is eroded by inflation. If the inflation is accompanied by rising interest rates, this will also feed through into higher mortgage rates, increasing monthly payments, pushing down prices and reducing capital gains.
So those concerned about inflation would be best advised to think about alternative assets. In particular, the price of gold tends to rise in periods of high inflation, living up to its reputation as a good store of wealth in difficult times.
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