26 February 2020

    Inflation Protection

    Which investments are best?

    Mark Brighouse (CFA)

    Chief Investment Strategist

    Email Mark
    Mark Brighouse (CFA)

    Chief Investment Strategist

    Email Mark

    The menu at Parrilla Peña in the theatre district of Buenos Aires has two clear differences from restaurants in New Zealand. The first is that there aren’t many vegetarian options and the second is that the prices are in pencil. This reflects two long standing Argentine traditions: one of the highest rates of beef consumption in the world and one of the highest inflation rates. With annual price increases of 50% or more, restaurant managers must adjust prices almost on a fortnightly basis, hence the penciled prices.  Imagine the struggle that workers face if wage increases lag price increases even slightly. Imagine the consequences for savers when any idle cash loses half its buying power over a year. Imagine the challenges for investors when some dividends rise with inflation and others get left way behind.

    As we have enjoyed low and stable inflation through the developed world for many decades, the need to find investments with inflation protection has clearly waned. But because of importance of being able to buy enough goods and services with your retirement savings we should never forget that some investment assets provide better protection from inflation than others. Even a 2% per annum increase in consumer prices results in a doubling in the cost of living over a 40-year working life.

    Lets take a look at how well some investment assets handle inflation.

    • Gold which is considered one of the most high-octane inflation hedges. Throughout the ages it has been a compact and easily traded store of value. Unfortunately, its price is highly volatile even when inflation is stable.

    • Shares in high quality companies can provide some protection if the companies have strong pricing power. If they are like the restaurant that can adjust prices easily then they can maintain margins even if costs are rising.

    • Overseas shares can provide an additional boost if inflation is a problem in your home country but not elsewhere. This is because the exchange rate can move in your favour in response to an inflation shock. Without a doubt, any citizens of Argentina with foreign investments will have been pleased to see their value go up as the peso has tumbled.

    • Long term government bonds perhaps provide the least inflation protection because they lock investors into a fixed income stream. However, many governments issue inflation-linked bonds which provide a stable income that is based on the inflation rate plus a margin. These offer an advantage over traditional fixed interest rate investments because the income rises with inflation.

    • Property’s performance as an inflation hedge depends on the nature of the leasing arrangements. Rental income that is fixed over a long term is more like a fixed interest investment but leases with annual CPI adjustments can provide better protection.

    • Bank deposits are often eroded by inflation unless the central bank lifts short term interest rates quickly in response. But this tends to happen with a lag so it is often the case that bank depositors don’t immediately get compensated for inflation with higher deposit rates.

    As these comparisons show, having a well-diversified portfolio is a good idea not only to protect yourself from short term market volatility but also from changes in your cost of living. While there isn’t much risk of very high inflation returning in developed countries there are still many parts of the world where it is a major challenge for investors. On the bright side, it is still free to use the air compressor at a service station, and that’s one place you would expect to see inflation.