How to invest in an inflationary environment

Inflation’s bite can inflict investment pressure across the board. But security can be found if you know where to look.

Peter Strachan

As we enter 2023 inflation is very much back in the spotlight. How did we get here?

The current cycle of headlinegenerating global inflationary pressure began back in 2020, when production and transport costs rose for many goods and services as the global pandemic constrained supply chain logistics. Subsequent stimulatory government spending added fuel to the inflationary fire, before Russia’s invasion of Ukraine boosted energy costs, turbocharging inflation through 2022. Higher prices for oil, gas and coal, along with the electric power generated from these fossil fuels, fed inflationary price pressure onto consumers so that households, manufacturers, and transport companies have all experienced rising costs, lifting prices through the economy.

To guard against inflation, investors should avoid eroding the value of cash that is held at interest rates below the inflation rate. Investment should be directed towards real assets with monetary value that rises with inflation

– things like equities backed by inflation-busting assets, quality industrial real-estate, commodities or collectables that hold value through inflationary periods.

Industrial Equities

An inflationary environment favours consumer spending on necessities, leaving discretionary spending vulnerable. Profit for companies relying on nondiscretionary spending on consumer staples like food, healthcare, utilities and alcohol is less affected by inflation. Businesses operating in discretionary spending areas, such as hospitality, clothing, travel, or entertainment, may struggle to maintain sales, cashflow and profitability as inflation bites.

Debt

While inflation lifts the monetary value of real assets in a balance sheet, the relative value of offsetting debt is reduced, improving gearing. Effectively, inflation reduces the burden of debt while revenue rises. Cash flow lifted by inflation renders debt repayment more secure. A higher risk approach to investing through an inflationary cycle may involve a selection of companies that offer expanding revenue from a solid asset base, supported by a moderate level of debt.

Commodities

After many years of underperformance, the energy sector is now outperforming the broader market on the back of stronger energy markets.

A lack of investment in new fossil fuel production capacity since 2014, when oil and coal prices slumped, left supply lines in a fragile state. A similar story has emerged for copper, aluminium, and nickel, where a period of marginal metal pricing held back investment in new capacity.

This market dynamic is likely to support higher metal prices through the 2020s, making investment in mining production companies and physical metals a reasonable bet through the current inflation period. Many resource companies have also become the new high yielding investment option. Companies such as Fortescue, BHP, Rio Tinto, South32, New Hope and Woodside are now offering dividend yields over 7% per annum.

Property

Listed real estate investment trust securities (REITS) offer high yielding exposure to all real estate classes. In an inflationary environment, most retail, residential and office focused REITS should be avoided as their underlying value could be at risk. Investment in industrial property and ‘big box’ shopping or logistics asset backed REITS should be preferred. Property trusts that have modest gearing, low vacancy rates, long-lived leases to a strong tenant register with annual rent reviews, as well as some development options, can sail through an inflationary period as assets appreciate, debt is devalued, and cash flow provides supporting dividend yields.

Rising prices for goods and services reduce the purchasing power of cash. Gold has maintained its relative value over many years, proving to be a good hedge against inflation. Think of it this way – the price of an ounce of gold continues to match the value of a quality business suit over time. More cash is required to buy that suit, because its value declines as inflation erodes its purchasing power, but gold has proven to be a hedge against general price inflation over the long term.

Floating Rate Notes

While cash is usually an underperforming asset, it’s always sound policy for investors to hold, providing an option on the future, sitting poised to take advantage of opportunities that arise. Investment in highly liquid, capital stable near-cash, floating rate notes that varying at a premium to the 90- day bank bill rate, offer enhanced franked dividends of 3.5 to 6% pa to provide a level of buffer against inflation. Inflation linked bonds are also available in some markets, protecting cash against value erosion.

ETFS

Exchange traded funds can offer direct exposure to metals and other commodities such as cotton, sugar or grains, as well as mining companies and a basket of property equities. ASX listed GOLD.ASX and PMGOLD.AXW are examples of ETF gold exposure. Care should be taken to ensure that the underlying assets are not over geared or subject to loss of cash flow as prices rise.

Reading the market in inflationary times can be a challenge, but it also highlights the value of seeking out the right advice and expertise when making investment decisions.