How should investors respond to a change in inflation?

Recently, we’ve seen more speculation that the huge economic stimulus packages from governments and central banks around the world could kick start inflation. It would be the first time we’ve seen meaningful levels of inflation in the UK since early 2019, and sustained inflation (when prices rise continuously) has been almost non-existent since 2011.

We’re not going to get into the different arguments for and against a rise in inflation here, so investors will need to weigh those up for themselves. But once you’ve decided if you think inflation is more likely to rise or to stay low, how should that affect your investment decisions?

This article isn’t personal advice. All investments can fall as well as rise in value – you could get back less than you invest. If you’re not sure an investment is right for you, please seek advice.

Investing in a low inflation world

If recent low inflation trends continue, then recent investment trends are likely to continue as well.

Inflation means money today is worth more than money tomorrow. Below you can see how different rates of inflation affect the future value of £100 today.

Imagine someone agreed to pay you £100 a year, starting now, for three years. Inflation would significantly affect how much that offer is worth. Regular payments at a fixed amount – in this case £100 – see their real value decline as inflation rises.

This is essentially how a bond works with inflation. As inflation rises, the value of future bond payments falls, and the price of the bond should fall too. The low inflation we’ve seen in the past few years is one reason why bonds have performed so well. If inflation stays low, then you’d expect that to continue.

What’s true of bonds is also true of companies to some degree – although companies can raise prices to offset some of the effect of inflation. Most sectors, including traditional safer havens like utilities and consumer goods, have tended to do badly when inflation rises. That could be because rising inflation usually drives higher interest rates – which significantly reduces the value of future profits compared to current profits.

That’s far more of a problem for businesses that are making only modest profits today but promise greater riches in the future. Low and long-lasting levels of inflation also works for companies with large cash piles.

Cash is very vulnerable to the effects of inflation because it generates little or no income. Companies that hold lots of cash on their balance sheet risk seeing the real value of that money shrink as it’s eaten away by inflation. Lower levels of inflation reduce that risk.

The promise of massive future profits, together with large cash balances, are two of the defining features of the large tech groups.

To give a few examples: Google parent Alphabet is expected to grow profit by the mid to high-teens in the next few years, and has $122bn of net cash on hand. Analysts are forecasting social media group Snap to go from a $944.8m loss in 2020 to a $756m profit in 2023 and currently has $862m of net cash. Amazon is expected to more than double its profits by 2023 and has $52bn of cash on hand. These are only forecasts, and there’s certainly no guarantee they will be delivered, but they illustrate the point nicely.

If inflation stays low, conditions for these sorts of companies should still be attractive and, along with bonds, are likely to stay strong performers. But what happens if inflation picks up?

Investing in a world of rising inflation

The first issue of rising inflation rates is the possibility of a shift in favour of companies who are making profits today, rather than tomorrow. It’s the opposite of what we’ve mentioned above. This would be good news for companies that are usually considered ‘value’ stocks.

In particular, it bodes well for companies with lots of assets and high amounts of debt. Inflation should increase the price of assets, but the value of debts stays the same. In the example below, we’ve imagined a mining company with £100m of reserves (ore still in the ground that it owns but hasn’t yet dug up) and debt of £70m.

All else being equal, the book value of the company (assets minus debts) has increased by £4m or 13.3%.

It’s this effect that makes commodity companies, like miners and oil & gas companies, stand out as winners when inflation is high. The value of the commodities they produce rises in line with inflation. But the debts they used to buy and build the mines or oil wells remains relatively fixed.

While the outlook for oil & gas names is complex – with long term demand for oil & gas unclear – other commodities are still key to the development of the economy. Whether it’s the steel that goes into new infrastructure projects or copper wiring in consumer electronics, we’ll continue to demand large amounts of these raw materials.

Commodity companies make up for 28% of the UK stock market – thanks to giants like Rio Tinto, BHP, Shell and BP. An inflationary tailwind for these names might also change wider perceptions of the UK market after a long period in the doldrums.

How do I decide what to do?

The long period of low inflation rates and strong performance from tech and other growth stocks has seen the proportion of portfolios invested in these kinds of companies increase. If we’re on the cusp of a shift in inflation rates, then it should pay to make sure your portfolio holds a broader range of investments.

Diversification – the investor’s tool we all need to talk about

However, as with everything in investing, we’re talking about a balance of probabilities – nothing is certain. Lots of traditional ‘growth’ shares are great companies, and there’s no suggestion investors should abandon them altogether.

But, having been neglected in recent years it could be worth reconsidering whether some commodity names deserve a place in your portfolio. If the future proves different to the past, they could be strong performers.

Unless otherwise stated estimates are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Past performance is not a guide to the future. Investments and income they produce can rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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