A diversified portfolio is critical to combat or reduce the effects of inflation. Different asset classes will respond differently when there are sustained inflationary pressures. Equities specifically will see a wide range of valuation impacts in a higher inflationary environment, and much of this is dependent on the demand for the services or goods of the underlying company. Put simply, if a good or service is in demand regardless of the price, then the companies producing this good or service are able to pass on their own increased costs to the consumer. This results in a predictable and consistent cash inflow for the company which will increase the share price and valuation. The below sectors have traditionally performed better and worse in inflationary periods:
The Impact on Growth Assets
A ‘rule of thumb’ in inflationary environments suggests it is best to have a reduced exposure to growth equities. Companies that look to aggressively expand and grow their business often fund this through borrowing or raising capital. So when central banks raise interest rates rise to combat inflation, they increase cost of borrowing and therefore it becomes more expensive for these businesses to operate. Growth companies without stable and predictable cash flow can experience a sell off as investors look to de-risk and protect their downside.
What do analysts mean when they say they use a discounted cashflow model to value a company?
Companies have a valuation for which investors can assess and make an informed decision on whether this is too high or too low. High growth companies often don’t have much to show for their current earnings or valuations, as much of their promise is tied up in future earnings. So, to produce a strong metric for valuation companies will use the discounted cashflow model. This is a valuation method which estimates the value of an investment today based of all expected future cash flows. The key variable in this valuation tool is the ‘discount rate’ or the interest rate which determines how much the future value of a company’s cashflows are worth today.
If interest rates and inflation rise this erodes the value of money, which means the future cashflows are worth less than they are today. This would bring down the value of such companies.
Investors tend to shift towards what are termed “defensive companies” that have strong cash flows and stable business models, preferably with a longer tenor in the marketplace.
The Impact on Defensive Assets
In a higher inflationary market, the value of any bonds within a portfolio will erode. This is because rising prices will diminish the purchasing power on the interest received on a bond.
For example, if there is a 10-year bond paying exactly $500 on a semi-annual basis, inflation will mean this $500 will buy less 10 years from now. If the markets are concerned that the return/yield on bonds will not keep up with rising costs, the actual price of the bond will drop due to lower demand for the product.
Fixed Coupon or Indexed?
Long term bonds that have a fixed coupon rate are of most concern when there is inflation. Whilst there is certainty in cashflow, if it doesn’t match the cost of living then your purchasing power is diminishing.
Indexed bonds provide an alternative to invest in – the stability of cashflow remains however the interest rate you receive will go up or down in line with changes in the Consumer Price Index, which is the core measure of inflation. The value of the bonds will increase when there is inflation but, decrease in value when there is deflation (this is the risk).
It all comes back to you and your objectives
When looking at the longer-term picture and depending on an individual’s personal circumstance, it may still be the right strategy to hold bonds in their portfolio as there can be a price to pay from chopping and changing investments. Playing devil’s advocate to the above points, bonds serve their own purpose for consistent cashflow and capital stability, and sometimes this needs to be factored in over a longer time horizon, not just a couple of years.
An advisor will be able to recommend a suitable mix of investment assets based on your goals, objectives and risk profile. As markets are dynamic, responding to an ever-changing world, the ability to rebalance and execute in a quick manner is critical. At one point in time, it may be prudent to trim bond holdings in a portfolio but if the market has factored in that interest rates are rising, there will be a time when it may make sense to increase the weighting of bonds as the macroeconomic environment changes. So make sure you’re talking to your advisor about how your portfolio is positioned to navigate volatile periods.
Luke Aitken is a Senior Financial Planner at Viridian Advisory.
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