How to inflation-proof your investment portfolio

The return of inflation is proving a nasty shock for investors. Here’s how to protect your wealth.

MoneyWeek has warned for some time that we would see inflation as the economy reopened following the pandemic. Covid-19 and our reaction to it created a unique set of circumstances: the economic shutdown meant that the supply of goods collapsed, while consumers and employees were in many cases stuck at home for prolonged periods of time. But incomes were maintained through government spending on furlough schemes in the UK and similar schemes in the rest of the developed world, so we had the most unusual recession ever: demand collapsed, but household balance sheets remained intact. As a result, when the economy reopened, demand surged and supply – hindered by the long shutdown – simply couldn’t keep up. The result was that prices rose rapidly. 

But there’s more to it than that. Central banks have until very recently been treating this inflation as “transitory” – something that will go away as soon as the supply chains are unravelled and the economy is back to “normal”. However, while the pandemic has accelerated the return to a more inflationary world, there are plenty of arguments to say we were heading that way already. 

The main factors driving the long-term disinflation the world has enjoyed since at least the 1990s no longer have the potency they once did. The opening up of eastern Europe and China, which created more avenues for trade while simultaneously giving employers a vast pool of cheap labour that suppressed wages across the globe, is now a spent force. Similarly, it’s no longer clear that the internet and technology in general represent a competitive pressure driving prices down – instead, the internet behemoths are increasingly accused of monopolistic power while the shift towards “green” energy technology will prove highly inflationary in the medium-term. 

Meanwhile, in the wake of the pandemic, governments are so heavily indebted that inflation (which reduces the “real” cost of debt by enabling a country to repay its debt with inflated currency) may well appeal as the least politically painful solution to getting public finances back in order. 

What this means for your money

What does all of this imply for your investments? A backdrop of persistent inflation – whether it’s moderate 3%-4% price rises, or double-digit 1970s-type surges – is something that most developed-world investors today won’t have seen during their adult lifetimes. But we’re already seeing the side effects in markets. As investors have started to fret that central banks will respond to higher prices by raising interest rates, speculative stocks have plunged. This is the key reason why the tech-focused Nasdaq index in the US has so badly underperformed the UK’s FTSE 100 in the year to date. The Nasdaq is home to the exciting growth and digital economy stocks that have done so well in the last five years or more. The FTSE 100, by contrast, contains “value” (cheap) stocks that operate within the boring old “real” industries – oil, mining, and consumer goods, not to mention high-street banks (which tend to benefit from higher rates). 

We suspect that this “great rotation” (as it’s sometimes described) from growth to value will continue as central banks try to walk the line between managing inflation expectations and ensuring that interest rates don’t rise high enough to bankrupt governments (and mortgage holders). This is all before you even consider the impact of the invasion of Ukraine. So if you’re looking for funds to put in your Isa that might help shield your portfolio from inflation, what should you consider? 

History suggests that once inflation rises above about 4%, life becomes tricky for most equities. But commodities, and commodity producers, can provide some protection. One option is to invest in BlackRock World Mining (LSE: BRWM) investment trust, which holds a portfolio of the major mining stocks from around the world. For wider exposure, opt for a simple FTSE 100 tracker, such as the iShares Core FTSE 100 UCITS ETF (LSE: ISF). The UK index is cheap compared with other developed markets, and contains a heavy weighting towards oil and miners, not to mention large consumer-goods groups that should have pricing power in an inflationary world. 

One thing we feel all investors should have a bit of exposure to in their portfolio is gold. It’s a useful hedge against both inflation and general market turmoil. You can invest via a fund such as the Royal Mint Physical Gold (LSE: RMAP). Finally, if you’re tempted to bet on value stocks, one popular option is the Temple Bar Investment Trust (LSE: TMPL), which counts oil major BP, energy provider Centrica and Royal Mail among its top holdings.

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