Inflation worldwide is on the rise, driven by fuel price hikes, the energy crisis and rising food prices. Locally, inflation is at its highest level in five years.
The sharp rise in inflation has seen central banks responding by hiking interest rates. Rising interest rates are impacting the performance of financial assets across the board.
In addition, shifting consumer spending patterns and preferences, because of higher inflation, have distinct implications for the performance of equity portfolios.
The impact on earnings will be different for different market sectors, and hence investors can expect divergent returns from their equity portfolios.
In addition, markets are likely to be volatile as they continue to digest new information about inflation and economic growth.
Within this context, investors need to be particularly discerning when selecting how to position their share portfolios. This is where financial advisers can add value to their clients, not only by helping to manage investors’ behaviour, but also through their understanding of the impact of inflation on market sectors and asset classes.
Rising inflation sets in motion a chain of events, with the knock-on effect most visible in rising interest rates, which has a negative impact on equity prices as a result of businesses and consumers cutting back on spending. This, in turn, causes earnings to fall, and equity prices pull back.
Energy and real estate
However, investors should not fall prey to the negative news and emotional responses that often surround the media’s reporting on inflationary pressures, because equities remain the asset class most likely to outperform inflation in the long run.
Investors should adopt a balanced outlook and follow a diversified approach, because – with the guidance of an experienced professional – it is possible to tilt portfolios to withstand the impact of inflation better.
For example, investors could consider sectors such as energy and real estate, which could help to buffer portfolios against the effects of inflation. Finding the sectors more likely to benefit from rising inflation will be key to constructing resilient portfolios.
For example, the energy sector, which is predominantly made up of oil and fuel companies, has typically beaten inflation 71% of the time and delivered an annualised real return.
The revenues of energy companies increase as energy prices go up, which is why the sector performs particularly well.
Real estate investment trusts (Reits) have also typically outperformed inflation 67% of the time, with an average real return of 4.7%.
Reits provide a partial inflationary hedge that acts as a pass-through of price increases, because the price increases in rental contracts and properties are passed on to the tenants. In so doing, the sector can factor in the increases.
In contrast, it is expected that the information technology sector will take a knock, because its estimated future growth in profits is likely to be a lot less valuable in today’s monetary terms. This is because the majority of the cashflows of these companies are expected to be realised in the distant future. Inflation will therefore have a corrosive effect on these returns.
Diversification and expert advice
We often say that investors should be cautious of trying to chase performance. As much as investors panic on the down, investors also battle to know when to return to the market. They believe the past performance of a share is reflective of its likely future performance, which is not necessarily the case. As always, diversification and seeking expert advice before executing big changes to an investment portfolio are key.
Wendy Myers is the head of securities at PSG Wealth.
Disclaimer: The views expressed in this article are those of the writer and are not necessarily shared by Moonstone Information Refinery or its sister companies.