Economist Richard Urwin, head of investments in the fiduciary mandate investment team at BlackRock, offers six ways to overcome inflationary pressures.

Inflation, Milton Friedman’s “old, old disease” is anything but a new problem. At present, however, the venerable economist’s ‘taxation without legislation’ is hitting the headlines because it has remained stubbornly above expectations for quite some time. In fact, while the Bank of England targets an inflation rate of 2%, this figure has more than doubled to 4.5% and is expected to drift even closer to 5% by the end of this year.

There are a number of reasons for this sharp rise. Commodity prices, considered by many as a bellwether for inflation and a direct input cost, have been climbing steadily, bolstered by increasing emerging market demand as well as supply tightening.

Government intervention, such as the rise in the UK VAT rate, has also contributed to inflation. In addition, sterling and the US dollar have both weakened, contributing to more expensive imports, and subsequently higher prices. Some also believe massive stimulus measures such as QE in the US and UK may have also fostered an inflationary environment.

Show me the money

In theory, cash on deposit is the easiest way to protect against inflation, although not during hyperinflation, such as that experienced in Zimbabwe or Weimar Germany. During inflationary periods, central banks typically raise interest rates to keep inflation in check.

This means cash sitting in a bank account tends to earn more money than it would in a looser rate environment. However, the extent to which cash can hedge against inflation is heavily influenced by the monetary policy regime of the relevant currency’s central bank. At present, the Bank of England is keeping rates at historic lows of 0.5% in an attempt to invigorate the economy after the recent financial crisis. As a result,cash is yielding lower returns than usual in higher inflationary environments and is not providing an effective hedge.

Where’s my share?

Equities can be a good inflation hedge over the long term but they tend to lag the rate of inflation and are subject to periods of volatility and underperformance. The idea is that as inflation increases, company earnings also increase, but more slowly. That said, when inflation abates, earnings tend not to fall as quickly.

High dividend-paying stocks can be a better antidote against inflation, particularly in a low-growth environment. Because of the consistent dividends paid by these companies, these can offer extra yield where cash or fixed income may fall short of investment requirements. That said, these high quality companies often come at a higher price. It is also essential to avoid ‘income traps’ – companies that pay elevated dividends for a short period of time, but do not have the cashflows to sustain these dividends and end up disappointing investors.

Linking in

Index-linked securities can also hedge effectively against inflation. Inflation-linked bonds carry an inflation expectation built into their price, often referred to as the break-even rate. Index-linked securities can be used to construct a portfolio to effectively hedge long-term inflation risk.

That said, inflation expectations as well as the risk premium required can change. As inflation worries rise, it is quite likely investors will be prepared to pay more for protection against that trend. As a result, investors need to ask how much risk they are running and what price they are willing to pay in order to hedge against it.