Protect your portfolio against rising inflation

With higher inflation looming on the horizon, experts assess what precautions investors can take

Inflation may be about to make a comeback. By how much and for how long remains a hotly debated topic, but it’s worth understanding how your portfolio might fare if it does lift and what changes you may need to make to guard against it. At the most basic level, price inflation occurs when there’s an increase in the price of goods and services, measured by the consumer price index (CPI). This can come from excess demand relative to supply, a shortage of supply relative to demand, or a combination of both. More than simply lifting the costs of your goods and services by a dollar or two here and there, inflation has wide-ranging ramifications on investment returns.

Flood of cheap money

If the prophets of doom are correct and inflation does strike, what will have caused it?

At this stage, it’s hard to point to any one thing. For years, economies around the world have received injections of cheap money, and lots of it. Global cash rates have been low for a long time – for example, the US Federal Reserve has kept the federal funds rate below 3% since the GFC.

The rock-bottom rates are coupled with unprecedented quantitative easing programs, which have seen central banks buy back government bonds from the banking sector, thereby providing banks with more cash in their kitties to loan out into the economy.

Then, perhaps most importantly, there’s US President Biden’s $US1.9 trillion stimulus package.

The impact of inflation on investment portfolios will depend on how much it increases and for how long, yet experts are divided.

Leading the warning calls is Lawrence Summers, former director of the National Economic Council in the Obama administration. For Summers, the impending risks hark back to the period immediately preceding the hyperinflation of the 1970s.

“As I look at $US3 trillion of stimulus, $US2 trillion of savings overhang, a major acceleration coming from Covid in the rear-view mirror, rates expected by the Federal Reserve to be at zero for three years even in a booming economy, record growth this year, major expansion of the Fed balance sheet, and much new fiscal stimulus to come – I’m worried,” he says. Others predict a temporary inflationary spike. “Over the next several months, a combination of base effects, recent increases in energy prices, and price adjustments in sectors where activity ramps up is likely to push year-over-year inflation rates significantly higher,” says a report by investment manager PIMCO. “However, we forecast that much of this rise will reverse later this year as full employment remains elusive despite the expected strong labour market recovery.”

In Australia, experts have more sanguine inflation forecasts.

AMP Capital chief economist Shane Oliver expects inflation will hit the Reserve Bank’s 2%-3% target over the next year to 18 months. “The risk is that we may see a period of overshoot given ultra-easy monetary policy now combined with reduced globalisation. Either way it will be higher than the last few years and consistent with higher bond yields than we have become used too.”

David Bassanese, chief economist at BetaShares, is more optimistic. “It’s still very likely that both Australia and the world will enjoy solid economic growth and falling unemployment rates over the next six months or so as we continue to shake off the Covid crisis. The question is whether strong economic growth per se will create inflation, which I doubt due to very competitive conditions in both product and labour markets and ongoing technology disruption.”

Assets under threat

To understand what needs to be done to guard against inflation, it’s worth understanding which assets are most threatened by it.

Assets can withstand inflation if they, or the income streams they generate, appreciate in spite of it. In other words, you want a “real rate” of return. So, if an asset goes up by 1% annually but inflation goes up 2%, then the value of the asset has shrunk by 1% in real terms.

Far and away the asset class most under threat from inflation is fixed income.

“Today, you are lucky to get over 1% on a bank term deposit,” says James Gerrard, director and certified financial planner at Financial Advisor. “Not only is a