Many wealth managers believe that the biggest threat to private client portfolios right now is not whether stock markets will plunge, but how much inflation will rise. For those running discretionary portfolios, the key questions are whether inflation will continue at its current rate, and whether the Bank of England will raise interest rates this year in an attempt to slow it down – with knock-on effects for clients’ investments.
Typically, they aim to protect clients against inflation by buying certain types of assets and avoiding others.
This week, figures showed that the retail price index (RPI) remained stubbornly high at 5.2 per cent in the year to May, while the consumer price index (CPI) is also stuck at 4.5 per cent – more than twice the Bank of England’s inflation target of 2 per cent.
Wealth managers say that inflation has major implications for the investment strategy adopted for their clients.
“It is difficult to find a safe haven for money to protect it in a period where inflation is higher than everyone’s hoping for,” says Jeremy Harvey, director at Cazenove Capital. “It is a challenge – particularly over a three- to six-month view.”
Inflation poses a direct threat to many assets in a typical portfolio, especially those producing income. With the Bank of England base rate at a historic low of 0.5 per cent, investors have been flocking to equity income funds as well as specialist funds focused on infrastructure or private equity. These can yield more than 5 per cent a year – but inflation now threatens to wipe this return out.
Dirk Wiedmann, head of investments at Rothschild, recommends that investors hold “real” assets – such as commodities, gold and property – which are likely to rise in value in line with inflation. He also thinks companies with low leverage and solid balance sheets should be able to maintain their dividend payouts in a downturn.
George King, head of portfolio strategy at RBC Wealth Management, says that equities are worth holding on to if interest rates begin to rise. “Rising interest rates can be a good thing, if they are taken as a sign that the economy is on the mend,” he says. “Our analysis shows that equities have performed well even when real interest rates are high and rising.”
However, the trap for portfolio managers at a time of higher inflation is holding too many bonds – as their fixed coupons lose their real purchasing power when prices are rising.
Some wealth managers have been turning to inflation-linked bonds, such as index-linked gilts.
“Inflation-linked bonds can be particularly valuable for more conservative investors who are both concerned about inflation and dislike the turbulence associated with investing in asset classes such as commodities and equities,” explains Wiedmann.
James Maltin, director at Rathbones, has been moving his clients out of conventional bonds and into index-linked government bonds, or gilts – but he warns that some gilts are pricing in heavy levels of inflation. “One has to be very careful on the prices as they have expectations as to where inflation may be. Some of them are quite expensive,” he says.
Some believe inflation-linked bonds are not worth buying at all.
Alan Higgins, head of investment strategy at Coutts, says: “Index-linked bonds are unlikely to provide protection against inflation given very low real yields and the potential for capital losses given the high interest rate duration embedded in index-linked bonds.”
Charles MacKinnon, chief investment officer at Thurleigh Investment Managers, is also avoiding index-linked bonds as he believes they are too expensive to serve a protective role.
Some companies have launched inflation-linked products to appeal to investors. M&G Investments, the fund manager, last year launched a UK inflation-linked corporate bond fund.
But wealth managers agree that the most secure way to protect against inflation at the moment is by buying the new index-linked savings certificates from National Savings & Investments. These five-year products, released by the government’s savings arm in May, will pay 0.5 percentage points more than the rise in RPI over five years on sums of up to £15,000. Payments will be tax-free, making them the only savings products that can guarantee to beat inflation for all taxpayers. Wealth managers say that every investor should have them in their portfolio.
“For smaller clients, that’s a great starting point – although we’re saying to clients at the top end that they might as well do it, too,” says Harvey at Cazenove.
Even so, Harvey believes that fears of inflation have been overdone. “We expect inflation to come down a bit over the next 12-18 months after some of the one-off things like commodity prices and VAT increases have eased,” he says.
He thinks it very unlikely the UK will return to the runaway inflation of the 1970s, when companies were not able to pass on price rises quickly enough.
“Most companies are protecting their margins,” he says. “Corporates have been the winners from the recovery – in many cases their profits have never been as high.” But, as a hedge against inflation taking off, Harvey recommends large-cap “blue-chip” equities, as these should be able to continue paying dividends in two to three years’ time.
