Asset Allocator’s Soapbox: The silent embezzler

Dr Ana Armstrong, chairman at Distinction Asset Management, examines ways to stop inflation eroding returns

Almost every investor has a long-term need to grow their investment portfolio at a rate above inflation. Any return less than inflation is actually destroying the purchasing power of that portfolio. We believe this silent embezzler of wealth is the biggest risk to most investors over the long term and although there is a very specific need for most to generate inflation beating returns, not many investments are designed with that objective.

The United Kingdom uses two measures to monitor inflation, the Consumer Price Index (CPI) and the Retail Price Index (RPI). Over the past 12 months the CPI index has risen 4.0% and RPI has risen by 5.3%. We expect that due to the massive debt and deficits in the West, inflation will remain much more persistent than the consensus view.

Western governments are incentivised to monetize their debt (print new money to pay old debt), thereby destroying the real value of that debt. Over the past decade, the UK M4 (a broad measure of money supply used by Bank of England) has risen from £0.8trn to £2.2trn (9.5% per annum growth). Generally when the growth in money supply is greater than economic growth, inflation is the result.

We believe inflation from this rapid increase in money supply has previously been masked by disinflationary forces coming from China. Outsourcing to emerging markets reduced the cost of goods produced and increased Western productivity dramatically. We believe emerging markets are now becoming an inflationary force, as their fight their own inflationary battles and compete for resources with the West.

This has put investors in a difficult situation. The fund management industry has been slow to create products with target returns and risk constraints aligned with their clients needs. Most products are linked to equity markets or bond indices and peer groups.

These products are blunt instruments which may beat inflation, but do not have this as their objective. Many cautious investors are drawn to the lower volatility and safety of government bonds. Unfortunately we believe many of these investors are at the greatest risk of losing ground to inflation in the coming years. UK 10 year gilts are yielding 3.7%, which is less than the most recent annual CPI figure.

Many investors look to equities as a higher risk potential to protect their portfolios from the ravages of inflation. However inflation can also hurt equity prices. Historically there has been a strong relationship between inflation and the multiple the market puts on earnings from equities.

As inflation rises the P/E (price divided by earnings) multiple of the market tends to fall. Unfortunately for investors who would look to equities to act as a hedge against inflation, the narrowing of P/E multiples have been particularly pronounced in periods when CPI has moved above 6%.

We believe the most robust way to invest in an inflationary environment is to consider a broad and diversified range of opportunities which can deliver a yield or capital growth above rates of inflation. In our inflation benchmarked multi-asset portfolios we are allocating capital to commodities which are driving inflation including oil, and have allocations to precious metals which are an alternative to fiats currencies whose values are being destroyed with rapid increases in money supply.

We are also allocating towards short duration high yield bonds, which yield more than inflation and do not exhibit significant exposure to rising interest rates or credit spreads. Equities from manufacturers of luxury goods and branded consumer items which have pricing power should be able to maintain profit margins in an inflationary environment.

We are also attracted to equities of companies with stable earnings in sectors which are paying dividend yields above inflation and growing their dividends as well. Telecoms and Pharmaceuticals stocks are our preferred sectors. Exposure to real-estate in countries where bond yields are low and rental rates are rising such as Switzerland are also attractive in a portfolio designed to deliver inflation beating returns.