Skip navigation Scroll to top
Scroll to top

How do we protect portfolios from inflation overshoots?

28 May 2021

Jeremy Sterngold, Head of Fixed Income

We frequently write about the topic du jour, namely inflation. Concerns over higher prices seems a common narrative, not aided by some alarmist headlines coming from the press. It is not difficult to understand why these concerns have arisen. Enormous fiscal and monetary stimulus, combined with speedy vaccination rollouts, has resulted in the economic recovery from the pandemic arriving much sooner than people could have possibly imagined. On balance, we continue to share the central bank view that these pressures are likely to be 'transient', as discussed previously within Why do central banks continue to see inflation as transitory? and Why has economic data confounded the forecasters? While the largest supply chain disruption in peacetime will result in inflation being above central bank targets for the next year or so, we do not believe that we are entering a wildly different regime in the medium term.

Rather than re-hash the reasons for these views, this article seeks to explore which sectors may face greater inflationary pressures and whether these costs can be passed on to the consumer. Intuitively, many investors expect inflation-linked bonds to be one of the better hedges against a more inflationary environment. However, this does not take into account how much inflation is already priced into these securities and whether general bond yields may rise as a result, thus offsetting some of the benefits. (For a more detailed overview of inflation-linked bonds, watch our Spotlight video here). In fact, our Investment Committee downgraded its view on US Treasury Inflation Protected Securities and UK index-linked bonds to neutral and negative respectively for these very reasons.

So if inflation-linked bonds no longer provide a sufficient offset to a more inflationary environment, what should investors do to protect from inflation overshoots?

Here is where we would advise investors to take a nuanced approach and look to the breakdown of recent inflation data and examine where the future overshoots may stem from. In general, inflation occurs when either demand outstrips supply or input costs rise significantly. At present, there are several industries that are facing one or both trends, something that tends to occur in most economic recoveries. Thus, the inflation that markets are gyrating over is not just the cyclical recovery from sharp deflationary pressures at the onset of the pandemic, but a shift in behaviours which keeps prices elevated.

Second hand car and truck prices, which have risen by 21% since April 2020 in the US, illustrate just why it is important to look at prices in closer detail and examine what it tells us about the future. Second hand vehicles have been buoyed by increased demand for car ownership during a global pandemic, which has seen public transport use decline heavily due to health concerns. At the same time, at the onset of the pandemic, car manufacturers that expected an "inventory overhang" as consumers usually spend less on new cars during tougher economic times, cut production and cancelled orders for components, such as microchips. Microchips, among other components, are now proving difficult to obtain, and some manufacturers have been unable to ramp up production of new cars as quickly as they would have been able to during more normal economic cycles. This has created a massive supply demand imbalance. The question is, will this insatiable demand for cars persist? In our view, we believe demand should start to fall. Those people who wanted to buy a car to travel during the pandemic have likely already done so, which likely means that future demand should be weaker, resulting in more normalised patterns for the second hand car market over time. This example illustrates why it is so important to look at inflation data in more detail before drawing conclusions about the future.

Ideally, investors seek to protect against a prolonged imbalance between supply and demand for certain assets that keeps prices elevated in the wider economy. A few ideas initially come to mind. We could see copper as a beneficiary of the move to more sustainable investments. However, China has come out strongly against speculators in the commodity market and the futures market indicates that prices are expected to fall in 2023. Oil, which was a big reason for the inflationary spikes in the 1970s could also rise as people go out and drive and/or fly more as they able to. While the sector has underinvested in future production, the migration to more renewable energy sources may see OPEC (Organization of the Petroleum Exporting Countries) nations ramp up oil production to curb any large prices increases as they seek to maximise profits while demand for fossil fuels remains high.

Given these mixed outlooks for typical drivers of inflation, how do investors avoid speculating on beliefs and construct a portfolio to beat inflation?

Whilst it may be tempting to invest in commodities or inflation-linked bonds, we believe the core focus should be on investing in companies with limited input cost pressures and a strong ability to pass on these costs to the end consumer. In other words, we focus on companies where profit margins should be more resilient due to a combination of high barriers to entry and strong pricing power. We believe this approach will result in a portfolio that will have favourable odds of outpacing inflation over the medium to longer term.              

 

Read more from The Brief.

This communication is provided for information purposes only. The information presented herein provides a general update on market conditions and is not intended and should not be construed as an offer, invitation, solicitation or recommendation to buy or sell any specific investment or participate in any investment (or other) strategy. The subject of the communication is not a regulated investment. Past performance is not an indication of future performance and the value of investments and the income derived from them may fluctuate and you may not receive back the amount you originally invest. Although this document has been prepared on the basis of information we believe to be reliable, LGT Vestra LLP gives no representation or warranty in relation to the accuracy or completeness of the information presented herein. The information presented herein does not provide sufficient information on which to make an informed investment decision. No liability is accepted whatsoever by LGT Vestra LLP, employees and associated companies for any direct or consequential loss arising from this document.

LGT Vestra LLP is authorised and regulated by the Financial Conduct Authority in the United Kingdom.