We need to talk about inflation

Three things your clients should know

August 2021

Graham Finlay

Vice President,
Strategic & Technical Sales

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10 MINS UNSTRUCTURED CPD

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Risk Disclaimer

This content is directed only to persons having professional experience in matters relating to personal investment (investment professionals) and should not be distributed to anybody else. It has been prepared for general information purposes only. It does not constitute advice (whether investment, legal, regulatory, tax or otherwise) provided by BMO Global Asset Management (EMEA) (BMO). Certain content in this document is based on our own reading of legislation, regulation, or guidance issued by a government or regulatory authority, as at the date of publication, which is subject to ongoing change. Tax treatment is based upon individual circumstances. BMO gives no warranty or representation, whether express or implied, that such content is up to date, complete, or accurate.

Investment professionals in receipt of this document should not rely on any of its content. They remain solely responsible for advising their underlying clients in accordance with their own legal and/or regulatory obligations and for taking their own independent advice as they determine is necessary.

To the extent lawful, BMO excludes all responsibility and associated liability for any loss or damage suffered by any recipient of this document who chooses to rely on its content, whether occurring in contract, tort (including negligence), breach of statutory duty, or otherwise, even if foreseeable.

Key takeaways:

  • Why inflation isn’t necessarily bad
  • How different asset classes perform when inflation is on the rise
  • What you can do to protect a portfolio from inflation but still hit a target outcome

US inflation figures recorded the biggest rise in mid-2021 since 2008, and this has compounded the nervous chatter about rising inflation that we have been hearing over the first half of the year.

Central bankers in the US repeatedly played down the threat of higher inflation with a “it’s just transitory” mantra…until the US Federal Reserve meeting mid-June, when there was a marked change of rhetoric.

To cut through the ‘noise’, we think there are three things you should be talking to your clients about: inflation may be coming, but it’s not necessarily bad; how different asset classes perform in an inflationary environment; and what you can do to protect your portfolio from inflation but still hit your target outcome.

Inflation is coming…

…well, maybe, but a little inflation is not necessarily a bad thing. In their mid-June meeting, the US Federal Reserve (Fed) changed their future expectations of inflation, with an earlier timeframe for interest rate hikes. This caused a sell-off in markets, but this instant alarm is misplaced. Since the Global Financial Crisis of 2008, markets have got used to an ultra-low inflationary environment but the Fed’s target rate has remained at 2%, indicating that it has been a struggle getting inflation high enough in the face of secular trends. Zero inflation is not good for economies; businesses are not as profitable, wages stagnate, and consumers have less spending power. Of course, very high inflation is also not good as it erodes the value of profits and savings.

But let’s not get carried away, yes, the Fed seems to have indicated that the mid-year uptick in inflation may not be as transitory as they had at first thought, but their policy signals that they are still expecting inflation to decline from these elevated levels. Of course, if your portfolio is heavily invested in fixed income, then even just a little inflation could erode your returns, so let’s take a look at how different asset classes perform when inflation is on the rise.

How will my portfolio perform?

Bonds are the obvious losers from inflation, as when you have a fixed stream of interest payments, inflation erodes the value of this income. Central banks use interest rate increases as a tool to control inflation, higher interest rates mean higher bond yields and the price of bonds go down to compensate for the higher yields. So when inflation is on the rise, the ‘mark-to-market’ value decreases and the face value of the your bond holding effectively decreases on maturity.

Equities tend to perform well when inflation is rising, especially when inflation is low and rising, as they have more tools to use to negate the impact of inflation, such as lowering their dividend pay outs and passing on increased raw material prices to their customers.

Equity performance may start to be impacted when inflation reaches high levels, but some alternative assets benefit from this environment. There are many types of assets that fall under the alternative umbrella, but traditional ‘real’ assets, such as property, infrastructure and commodities, tend to perform well in periods of medium to high inflation.

Asset classes react differently according to the level of inflation
Level of Inflation table

Protecting and profiting

So if we know how certain assets perform when inflation is rising, then we should be able to position a multi-asset portfolio in a way that protects against the eroding impact of inflation and also profits from assets that go up in value when inflation goes up. Whilst this is true, investors need to be aware of blanket allocations to asset classes and they also need to understand how certain asset classes correlate – i.e. will they all move in the same direction at the same time.

When inflation is rising it makes sense to bias your portfolio to equities. But a blanket allocation may come with pitfalls. Not all equities are equal, and it is important that investors understand the drivers of returns so that they can avoid areas of equity markets that are expensive and allocate to stocks that have good prospects for future growth.

When inflation is rising it makes sense to bias your portfolio to equities. But a blanket allocation may come with pitfalls.

It is important to diversify your portfolio across asset classes that are uncorrelated and will move differently from each other in different market environments, and also to have a clear idea of what your client wants their portfolio to achieve: high growth, capital preservation, or maybe a steady income.

Real assets, such as property or commodities, tend to move upwards with inflation, so if you have a high target return these assets could help you get there. But again, there are risks to consider here. Some alternatives, such as property and infrastructure assets, can be relatively illiquid compared to traditional assets, can also be more expensive to invest in and can be sensitive to interest rate increases.

It’s good to talk

It may be tempting for investors to ignore the issue of inflation because it sounds complicated and scary. But talking through the options available for protecting multi-asset portfolios, as well as explaining the asset classes that profit from higher inflation will lead to a better understanding, and therefore outcome for your clients. This may also be a good time to revisit your clients’ requirements, do they still want the same outcome from their portfolio, and has their attitude to risk changed? This will determine the way they view the threat or opportunity of a higher inflationary environment.

Risk Disclaimer

This content is directed only to persons having professional experience in matters relating to personal investment (investment professionals) and should not be distributed to anybody else. It has been prepared for general information purposes only. It does not constitute advice (whether investment, legal, regulatory, tax or otherwise) provided by BMO Global Asset Management (EMEA) (BMO). Certain content in this document is based on our own reading of legislation, regulation, or guidance issued by a government or regulatory authority, as at the date of publication, which is subject to ongoing change. Tax treatment is based upon individual circumstances. BMO gives no warranty or representation, whether express or implied, that such content is up to date, complete, or accurate.

Investment professionals in receipt of this document should not rely on any of its content. They remain solely responsible for advising their underlying clients in accordance with their own legal and/or regulatory obligations and for taking their own independent advice as they determine is necessary.

To the extent lawful, BMO excludes all responsibility and associated liability for any loss or damage suffered by any recipient of this document who chooses to rely on its content, whether occurring in contract, tort (including negligence), breach of statutory duty, or otherwise, even if foreseeable.

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