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How should investors protect portfolios from rising UK inflation?

Investment experts share their tips on how to prevent inflation from eating into returns.

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Feb 15, 2017
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Michelle McGrade, chief investment officer of TD Direct Investing

Investors should look for companies with high barriers to entry and pricing power. Those paying dividends provide a further return, whether you choose to take the income or reinvest it. As interest rates rise, banks are likely to recover their margins and become dividend cash cows.

While inflation negatively impacts bond markets, index-linked bonds protect the value of investments. Additionally, inflation can be closely correlated to the price of oil, commodities and infrastructure assets, like toll roads.

There are two key things to consider when trying to insure portfolios against inflation. First, asset classes intended for inflation protection should be genuine inflation hedges. Second, it is not only important to consider whether a particular asset class is inflation-proof but also the correlation of asset classes to each other. A diversified portfolio of uncorrelated assets gives a better chance of at least some of those assets providing protection at different points in the cycle.

Jordan Sriharan, head of fund research at Thomas Miller Investment

Equity markets have typically been a natural hedge against inflation. Companies able to adjust pricing quickly are best placed to react to - and even benefit from - inflationary pressure. Higher cash flows from higher prices can generate greater profit for shareholders. Traditionally, food retailers have benefited from some inflation, as they are able to adjust pricing quickly, and often in anticipation of actual price rises, helping them cushion margins.

Investors can also look to index-linked bonds issued by governments and some corporates). However, UK index-linked bonds appear rich relative to their more medium-term range.

Ryan Hughes, head of fund selection at AJ Bell

Inflation can eat into investment returns and erode the real value of assets. Aside from the obvious strategy of investing in index-linked gilts, one way to protect portfolios is to focus on dividend growth. Stocks that are able to consistently grow their dividend payments can provide a natural buffer against rising inflation.

A high quality equity income fund such as Artemis Income is a good choice here. Managed by experienced fund manager Adrian Frost, the fund is well diversified and looks to produce a rising income by ensuring it focuses on companies that offer dividend growth rather than just an outright high yield, which helps offset the impact of increasing inflation.

That said, the current yield of 4.2 per cent looks attractive, with Frost finding opportunities in larger UK companies such as BP and GlaxoSmithKline. Over the years, he has also shown skill in finding opportunities in mid- and small-caps, and occasionally looks overseas should opportunities become apparent.

Guy Foster, head of research at Brewin Dolphin

The classic protection would be inflation-linked bonds. However, prices are already discounting a significant or sustained overshoot of the UK’s inflation target, so anything less might mean you were better off in conventional bonds.

More importantly, bonds in general will see their prices fall if interest rates rise, which is likely if inflation does pick up. Alternatively, high UK inflation will depress the value of the pound so buying anything abroad gives investors a good chance of protecting against it. That said, currency alone will not help if the foreign currency chosen experiences the same problems.

Equities will see their values impacted by inflation. Again, it is important to identify the source and type of inflation, as rising costs could be bad for cyclical stocks, whereas more defensive ones may underperform if consumer demand drives prices up. In the medium term, we think cyclicals have further to rise. However, right now, inflation and tighter bond markets suggest defensives are due for a rally.

Adrian Lowcock, investment director at Architas

With inflation returning this year and expected to peak at 2.8 per cent in 2018, protection will become a priority for many investors. The biggest issue, though, is that its return has been well publicised, which, in turn, has driven up the cost of traditional inflation-proof assets such as index-linked bonds. These assets now look more expensive and only remain attractive if you think inflation will rise above current expectations.

That leaves alternative assets, such as infrastructure projects and long lease contracts (airline leasing), where the income generated has some inflation protection and investors can benefit from a fairly reliable income over many years; usually decades. These assets have yet to respond to inflation expectations as they are not mainstream investments.

The return of inflation and expectations of interest rates rising resulted in a rotation out of defensive growth stocks, commonly known as bond proxies. However, as interest rate expectations peak, bonds will stabilise and yields on both them and stocks will look attractive, with rising inflation making the bond proxies appealing to retirees once again.

Gold is a long-term inflation hedge, although in recent years it has been subject to volatility. That said, it still plays an important role in portfolios.

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