Global Inflation and our Portfolio

Prices are rising quickly across the developed world, with inflation in countries that belong to the OECD surging to the highest rate since 2008.

Energy price hikes boosted average annual inflation across OECD. That’s the fastest rate since October 2008, when the global financial crisis delivered a massive shock to the world economy.

But prices are rising across the world even when volatile food and energy costs are excluded. 

On Wednesday, the Bureau of Labor Statistics announced that consumer prices in the United States rose 6.2% over the past year. 

As it happens, Eurostat, the statistical agency of the European Union, has released their annual estimate and as the U.S. report, this estimate showed inflation hitting a much higher level than expected at 4.1%. 

In the UK the Consumer Price Index for the United Kingdom for the year to date is 3.0% and the forecast for 2021 is 3.9% – 4.2%. 

Should you be concerned about inflation and your investments? 

If you have a substantial portion of your portfolio in securities, the answer is a definite yes.

Inflation erodes your purchasing power, and retirees suffer when their nest eggs buy less each passing year. 

Therefore, financial advisers should caution clients to start looking for assets that are a hedge against inflation.

The more cash or cash equivalents you hold, the worse inflation will punish you. A $100 bill under the mattress will only buy $96 worth of goods after a year of 4% inflation. Look for inflation-indexed products like the Treasury I Bonds and other products that offer a hedge against rising rates.

In addition, professionals should keep an eye on interest-rate-sensitive stocks and companies that benefit from inflation. 

What are the best stocks for inflationary periods?

Since inflation increases the cost of goods, businesses with less reliance on raw materials could be expected to perform better than those with cost-intensive products. 

Blue-chip stocks may also perform better than growth stocks during inflationary periods because they carry less debt. Any rise in interest rates will increase operating costs for a company that depends on debt-fuelled growth. 

Banks of course are on the other end of that equation – their profit on loans increases when interest rates rise but they have different problems to solve that I will not discuss in this article. 

Alternative Investments as a hedge for inflation. 

Since the beginning of the year, the distribution of COVID-19 vaccines, abundant fiscal stimulus, and the lifting of restrictions on many activities have fueled the economy and generated a resurgence of optimism among consumers. This has fueled a massive investment flow into alternative strategies but are they the right investment in our battle with inflation? 

We cannot in this article explore all alternative strategies but I will discuss the two main strategies that account for over 80% of all alternative investments today. 

Residential Real Estate and rental agreements linked to the CPI 

As a “real” or physical asset class, real estate is often sought after for its diversification and inflation-protection characteristics. Value from investment real estate is tied directly to its appreciation potential and expected cash flows associated with income generated by users of the property. 

It’s a broad category though, with a wide range of risk/return profiles and property types. 

Income-producing real estate linked to the CPI appeals to investors for its relatively stable source of return to a portfolio. Currently, high-quality private commercial property yields exceed those of high-quality bonds, providing a larger potential income cushion to a portfolio to offset inflationary impacts. 

Unlike traditional bonds, where the coupon rate is fixed at the point of issuance, real estate-generated income may grow over time as a result of rising rental agreements. In an inflationary environment characterized by a strong economy, increasing construction input costs, and demand for space that outstrips available supply, real estate investors could benefit from both higher rental income and property appreciation. 

Private Credit

Private credit investments involve debt financing transactions that occur outside of the traditional public markets. Direct lending is a subset of the space that focuses specifically on loans to private middle-market companies that might not have access to traditional bank financing. These obligations are typically collateralized with senior, first-lien positions against the assets of a company. 

Direct lending strategies benefit from relatively high yields and low-interest rate risk because the interest charged on the loans “floats” with increases or decreases in a short-term loan rate— a structural feature that may increase inflation protection. And while there are publicly traded debt securities with floating interest rates — most notably the leveraged loan market— the direct lending market typically benefits from higher interest rates.

Considerations when investing in direct lending include credit risk, a relative lack of liquidity, and the negative effect of ordinary income tax applicable to the income generated to taxable investors. Given the importance of credit selection and the strategy’s buy-and-hold nature, it’s important that investors gain access through a professionally managed vehicle that reduces or eliminates voluntary liquidity, and which necessitates investor commitments for a period that could exceed five years.