Ashley Gardyne: How to invest in an inflationary environment

OPINION:

The unexpected spike in domestic inflation to 3.3 per cent recently has not only pushed up mortgage rates and caused some borrowers alarm, but it has also provided a wake-up call for share market investors. It leaves them pondering if this sudden bout of inflation will be prolonged and how to position for it.

These are important questions, but the answers aren’t straightforward given predicting economic outcomes and market movements is fraught with difficulty.

Is inflation here to stay?

The recent spike in inflation is hard to ignore. Post-Covid supply chain pressures have resulted in low inventories and delays in consumers getting their hands on everyday items.

Have you tried buying furniture lately? Expect a 6-week to 6-month delay. Shipping and freight costs have also spiked. And don’t even mention timber prices – which spiked 400 per cent from the depths of Covid to the May peak (although they have retreated lately). At an aggregate level, we see these pressures in the inflation data, both in New Zealand and around the world, with US headline inflation hitting 5.4 per cent in June.

Investors in bonds and term deposits will have a real problem on their hands if inflation stays high for a sustained period. The key question is therefore how long this current spate of inflation will last.

Those who expect the higher inflation to last argue that inflation causes inflation. Higher prices result in workers demanding pay rises, which businesses then pass on via higher prices. And around and around we go.

On the other hand, there is a real possibility that inflationary pressures will fade as Covid supply-chain disruptions diminish, and global government support programmes disappear. This time next year, inflation may be in the rear-view mirror. We may be in an environment of low growth, low inflation, and low interest rates – just like much of the last decade.

Inflation hedges don't always work as expected

If you were an investor who, this time last year, saw inflation coming – and I’m not aware of anyone who made that call – what would you have done?

Many traditional macro investors would have suggested loading up on gold as an inflation hedge, expecting that a bout of inflation would push gold prices higher. If that was your trade – selling shares and buying gold – you would now be very disappointed. Over the last year gold is down 7 per cent, while global shares are up over 30 per cent.

My point is that trying to invest based on macroeconomic forecasts is a tough game. Even if you guess the economic scenario right – and most can’t – you still have to pick investments that will benefit from it. So basing investment decisions on macroeconomic factors is about as easy as predicting what the weather will be like this Christmas.

Investing in the right businesses can help manage long term inflation risks

While share markets can be volatile in the short term, the real earnings growth provided by listed companies can offset the corrosive impact of inflation. Over the long term the capital growth and dividends provided in the share market have allowed investors to significantly outstrip inflation – something that bank deposits and bonds will struggle to do in a low interest rate environment.

US fund manager GMO recently published an article examining the types of share market investments that do best in inflationary environments. GMO studied the eight periods since 1933 when US inflation spiked above 5 per cent for more than a year. They found that high quality businesses, trading at reasonable valuations, outperformed the market in seven out of eight periods.

These companies outperformed the market by an average of 5 per cent per annum, and delivered an average annual return of 12 per cent – even in periods of higher inflation.

High quality businesses with sustainable competitive advantages – like Mastercard and Xero – tend to have higher pricing power and wider margins than most businesses. This allows them to better manage inflation and pass on rising costs.

Investing in well-managed and growing businesses is a sensible way to build wealth over the long term. This approach has done well through countless economic cycles, both in periods of sustained high inflation, and in periods of low growth and inflation. It also avoids the need to guess how long this bout of inflation will last.

– Ashley Gardyne is the chief investment officer at Fisher Funds.

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