How to shield your portfolio against inflation

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How to shield your portfolio against inflation

Asset allocation strategies for an inflationary situation
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Highlights 

  • US inflation rocketed to 7% in December, the highest in 40 years.
  • Other countries in the Europe and Asia are also witnessing consistent price increases.
  • Three-year and five-year bond yields in Australia have been on the rise since last September.

One thing that is troubling most of the central bankers at the moment is inflation. With crude prices hitting a seven-year-high and Omicron-triggered supply chain disruptions, prices of most essential commodities are rising now. In the US, inflation has jumped to a 40-year high of 7% in December. Other countries in Europe and Asia are also witnessing consistent price increases. Although Australia is still in a better place as far as inflation is concerned, sooner or later, it will start haunting investors. So, is your investment portfolio ready to bear the inflation shock?

Bond markets have already started pricing in higher inflation. Three-year and five-year bond yields in Australia have been on the rise since last September. Although Australian equity indices have not reacted negatively to the rising bond yields yet, they will soon start feeling the inflation pressure if this goes on for long.

Once the US Fed starts raising interest rates, the excess liquidity available in the market will be sucked out, leading to correction in overvalued stocks such as technology shares, which are trading at exorbitant PE (price/earnings) multiples.

As bond yields rise, the attractiveness of risky assets like equity, comes down, and investors rush towards fixed-return bearing assets such as bonds, which are less risky.

ALSO READ: UK inflation surges to a 30-year high level: What to expect now?

Asset allocation strategies for rising inflation

While it is true that higher inflation impacts the share prices of companies, all sectors do not react uniformly to rising inflation. Stocks with low valuations are likely to remain less affected by inflation. Analysts say companies that can pass on the raw material price rise to their customers are safer investment bets during a high inflationary phase.

"No equity sectors provide consistent protection against inflation, but Energy, Materials and Healthcare are strong relative performers. Consumer sectors as well as financials generally underperform," Macquarie Wealth Management mentioned in a note dated 18 April 2021.

 Portfolio diversification crucial to asset allocation

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Don't ignore economic growth

While making asset allocation decisions, investors should also consider economic growth along with inflation.

In a situation where you see both higher inflation and higher GDP growth, value and cyclical stocks tend to do well. But in cases where inflation remains high but growth stalls, defensive stocks tend to do well.

ALSO READ: How would inflation further affect sectors? 5 pointers to note

Worth mentioning here is that sustained equity market underperformance usually happens when growth fundamentals deteriorate and central banks resort to rate hikes to bring down inflation. A temporary spike in inflation due to supply chain disruptions, which we witnessed during the first and second waves of the Covid-19 pandemic, usually does not result in sustained equity market underperformance.

What surprises the market is "unexpected" inflation and may lead to a high level of equity market volatility, Macquarie said in the note.

Real assets can be a hedge against inflation

Precious metals like gold and real estate have historically held their value in an inflationary phase. For instance, in the last one month since 21 December 2021, spot gold prices have risen from US$1,788 per ounce to US$1,840 levels on 21 January. So, investors can partially hedge their portfolios by allocating money to these assets. Buying shares of gold miners is another way to hedge your portfolio against inflation.

ALSO READ: How will slowdown in China's GDP growth impact Australia and other countries

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