Helen Fowler looks at how an equity portfolio could be optimsed for inflation sensitivity

In Europe, the inflation picture is mixed – the UK’s inflation remains stubbornly high, while the euro-zone’s index has been sliding for the past two years. US numbers look more like the euro-zone’s than the UK’s. Still, a growing numbers of investors believe western economies should be bracing for a period of renewed inflation.

“It’s possible that inflation could go up as the impact of quantitative easing feeds through and the economy picks up,” says Phil Edwards, principal at investment consultancy Mercer.

If inflation continues to rise, equities could suffer.

“Everything except real [inflation-linked] bonds suffers when inflation goes up,” says Kurt Winkelmann at MSCI Research. “The short-term effects of inflation on discount [rates] are not good.”

His firm is working on an inflation-hedged equity index in response to client demand.

“We hear from clients that they are interested in inflation,” said Winkelmann. “We are trying to get an early jump on this. The work we are doing right now is looking at how you would build a portfolio that is more or less responsive to macro conditions. What we discovered in our research was that there was a difference across equity strategies and sectors in their responsiveness to inflation.”

It seems that small caps have generally tended to fare better than large caps during persistent inflation shocks, perhaps because larger firms are more closely correlated to economic shocks. And international exposure can help, too.

“It’s probably advisable to have international exposure because interest and inflation rates have converged globally,” says Charlie Crole, responsible for the institutional client service and business development team at Jupiter Fund Management, which has also spent time researching how best to protect equity portfolios from inflation and is considering launching an ‘inflation-aware’ product. “There are many more global solutions than 10, 20, 30 or 40 years ago.”

Escalating costs are typically the biggest hurdle facing companies in an inflationary environment.

“It’s only over time and to varying degrees that companies can pass on price rises to consumers,” says Edwards. “Companies that can pass on price rises will provide a greater degree of inflation protection. Also, those with high barriers to entry and price insensitive consumers. For example, firms selling necessities, such as utilities and consumer staples, tend to do better in an inflationary environment.”

Some hold that finance firms, insurers and property companies do less well than the market.

“There is a strong link between profitability and the prices such companies can charge,” says Crole. “[Finance sector firms] faced severe competition and were vulnerable to higher interest rates. They also had less ability to pass on costs. For example motor insurers lacked pricing power and did badly relative to other sectors as a result.”

Not everyone agrees that the economics are so straightforward, and counter-arguments are easy to find.

“Food manufacturers face price inelasticity in passing on higher costs to consumers and so tend to do worse in inflation than other enterprises,” says Ewen Cameron Watt, chief investment strategist at the BlackRock Investment Institute. He also points out that the state of an entity’s balance sheet can be a factor in whether it will see inflation as a threat or welcome it as a balm. “If you have inflation anywhere in the western world, the banks would be happy because the nominal value of debt would be inflated away,” he reasons. “Inflation is good for banks.”

Indeed, that question of financial health complicates things further: just as inflation helps indebted banks and governments shrink the real value of their liabilities, Cameron Watt suggests that finance directors of companies with substantial pension fund deficits could welcome a short bout of inflation, as long as their index-link is capped.

Moreover, one of the issues facing investors is determining what kind of inflation they might be facing – ‘cost push’ or ‘demand pull’. Think about how manufacturers, in particular, are affected: inflation tends to increase the cost of replacing assets (‘cost push’) while at the same time increasing profits via the rising value of inventories (‘demand pull’). Demand-pull inflation generally puts them in a better position that cost push.  

In today’s environment, it is cost-push inflation that presents the biggest risk, according to Crole. “With the domestic economy only slowly emerging from recession and few supply-side constraints, currently inflation is likely to be mainly a cost-push phenomenon,” he says. “Cost-push inflation mainly relates to factors not directly linked to the strength or weakness of the domestic economy, and the most important of these are commodity prices. The developed world as a whole is now competing to a much greater extent than before with the developing world for access to global commodities.”

But whereas this can be tough for manufacturers meeting domestic demand with rising costs, just as diversifying internationally at the portfolio level can help against inflation, so diversifying at the company level can help, too. Germany’s BMW is the type of firm that might work as an effective hedge in cost-push inflation, suggests Crole, since the car maker plays to strong Chinese domestic demand. “It works as a hedge in a cost-push inflation environment if that inflation is being driven by Chinese growth,” he says.

The picture turns out to be surprisingly complex. Even once you have decided that inflation is a threat – and the past few years have taught us not to trust big calls on that front – its impact on equity sectors is contentious, influenced by the type of inflation it turns out to be, where in the world it is concentrated, and idiosyncratic elements such as balance-sheet strength.