Sharply rising inflation puts focus on hedging strategies

Inflation is firmly on the rise and looks set to remain high for longer than most investors have experienced in recent memory. We look at how to prepare portfolios for the new world.

Australia’s inflation rate has soared to its highest levels for over 20 years making it imperative for investors to think about protecting their portfolios to ensure the purchasing power of future returns will match investment goals.

But as this latest bout of inflation is emerging in a Covid pandemic era which has seen massive monetary and fiscal stimulus, huge supply chain disruptions plus a disastrous war in Ukraine, new thinking on inflation hedging strategies will be needed.

Over the twelve months to the March 2022 quarter, Australia CPI rose 5.1% due to higher dwelling construction costs and automotive fuel prices, according to the latest data from the Australian Bureau of Statistics1.

A similar picture is emerging around the world with the International Monetary Fund (IMF) projecting in its recent April Economic Outlook2 war-induced commodity price increases and broadening price pressures would lead to inflation of 5.7% for advanced economies in 2022. This is 1.8 percentage points higher than the IMF projected just in January.

The good news for Australia is that while the Reserve Bank’s central forecast is for headline inflation of around 6% in 2022 and underlying inflation of around 4.75%; by mid-2024, headline and underlying inflation are forecast to have moderated to around 3 per cent.

At the same time, the RBA said the outlook for economic growth in Australia remains positive. It expects domestic GDP to grow by 4.25% over 2022 and 2.0% over 20233.

“Central banks will be forced to live with inflation, in our view, to avoid destroying growth and employment,” investment giant BlackRock said in its market outlook.

Inflation-fueled assets key

Traditionally when it comes to inflation, the safe havens investors look to are real estate and infrastructure firms, companies with strong pricing power who can pass on rising costs, even gold can start to shine. However, this time the drivers of inflation, the potential short-term nature of the inflation cycle and the solid prospects for economic growth favour a wider range of assets.

David Schassler, Portfolio Manager and Head of Quantitative Investment Solutions Group, VanEck, suggests investors focus on assets that benefit from higher inflation. These are assets that, historically have significantly outpaced inflation during high inflationary periods. They include commodities and companies that benefit from higher commodity prices, and companies with revenues tied to tangible real assets, like REITs.

“With higher inflation, real assets have finally awoken from their decade-plus hibernation, and most are leading the markets higher," Schassler said.

Rising rates, commodities favour key equities

The boom in commodity prices, which is driving much of the rise in inflation, and the prospect of rising interest rates, tends to favour some of Australia’s strongest equity sectors: the Financial, Materials and Energy sectors.

The fact is that financial, materials and energy stocks comprise almost 60% of the S&P/ASX 200 index, led by names such as BHP Group (ASX:BHP), Commonwealth Bank of Australia (ASX:CBA), National Australia Bank (ASX: NAB), Westpac Banking Corp (ASX: WBC), Macquarie Group (ASX: MQG), Australia and New Zealand Banking Group (ASX: ANZ), Rio Tinto (ASX: RIO), and Fortescue Metals (ASX:FMG).

Analysts at JP Morgan have noted that these types of equities tend to do well in inflationary environments as long as the economy is still expanding because corporate earnings will remain strong. 

“We believe equities of companies that are more directly tied to economic activity and interest rates would be likely to outperform. The relative valuations of bank stocks, for example, are historically tied to inflation expectations. Companies with pricing power in cyclical industries such as industrials and materials could see robust revenue growth.

“On the other hand, the stocks that tend to do best when growth and inflation are scarce (think the digital economy) could be at more risk,” the bank said in a research note.

Market movers

AUSIEX data shows trading activity had already begun to focus on these heavyweight sectors in Australia which tend to benefit from rising inflation.

During the first weeks of 2022, the dominance of those financial and mining sectors was clearly pronounced as heavyweights such as BHP and Fortescue Metals accounting for 29.65% of total trades, while financials such as CBA and Magellan Financial Group (ASX:MFG) represented 21.95% of the total. 

More traditional inflation hedges can be tapped through the EFT market.

Betashares offers ETFs in sectors such as food producers (ASX:FOOD) and energy producers (ASX:FUEL). These are sectors that fit the description of featuring companies with strong pricing power who will be able to pass on the higher costs of their output due to largely inelastic demand.

Global food prices have lifted strongly in recent months, reflecting solid demand along with supply bottlenecks while energy companies have seen their performance positively correlated with trends in global oil prices.

Betashares along with other ETF providers also offers ETFs for mining companies and banks.

Commercial real estate to benefit

Another favoured sector for hedging inflation exposure are real estate investment trusts (REITs), and exchange traded funds (ETFs) on REITs, especially those focused on the commercial real estate (CRE) market which is set to benefit as the pandemic eases.

CRE debt yields combine the standard base rate plus a margin on the loans to account for any risk posed by the borrower, so any increase in interest rates caused by increases in official rates directly results in higher returns to investors, provided of course margins remain stable.

Commercial real estate (CRE) debt market is dominated by the banks, but non-bank operators have grown their market share recently by operating specialist funds.

Property investment management company Charter Hall Group (ASX:CHC), is one such firm which offers access to unlisted commercial property. It has found that in periods of higher inflation, the tendency has been for annual returns of commercial real estate to be elevated.

“Commercial real estate has historically provided a solid hedge and performed well in periods where inflation increases against the backdrop of economic expansionary periods,” it said in a note to investors.

“There are several inflation protections built into commercial property leases, particularly long-term leases. These generally include annual fixed increases, often at a given rate above the Consumer Price Index (CPI) rate. For example, a long-term lease in an industrial property might have annual rental payment increases structured at a fixed percentage plus CPI.”

The ASX provides access to a wide range of Australian real estate investment trusts (A-REITs), many of which focus on different sectors of commercial real estate. Charter Hall’s Long WALE REIT is an A-REIT investing in real estate assets that are predominantly leased to corporate and government tenants on long term leases.

UK investment firm Aviva Investors suggests investors keep their focus on real assets such as subsidised renewable infrastructure, long-lease real estate, and inflation-linked private debt.

Subsidised renewable energy companies often sell energy at a guaranteed price, backed by the government and linked to inflation. Although the amount of income generated depends on the operational output of that asset, this risk is mitigated since these are established technologies with limited variability of output.

Long-lease real estate is structured so most, if not all, of the value of the asset is in a long-term lease to a strong counterparty, with rent reviews linked directly to inflation. These can be on either an amortising basis, where the tenant retains ownership of the property, to provide a pure bond-like return, or on a more traditional reversionary basis where investors manage the risks and rewards of property ownership beyond the end of the lease.

Private debt is at the least risky end of the spectrum. It provides pure contractual bond cashflows with low volatility. The focus of index-linked debt in this market tends to be on infrastructure, including loans to fund public or private sector investment in schools, hospitals, utilities, roads, bridges, airports, or renewables. While its strong cashflow-matching credentials means a lower return, private debt still offers a significant pick-up relative to public market debt, largely reflecting an illiquidity premium.

With the growing certainty of increased rate rises, rising inflation and volatility from geopolitical tensions, investors may benefit from strategies that offer insurance for their returns.

1 Consumer Price Index, March 2022

2 IMF World Economic Outlook, April 2022

3 Statement by Philip Lowe, Governor: Monetary Policy Decision, May 3 2022