Interest Rates and Inflation: Time to Inflation-proof your Portfolio

As we contemplate the Fed’s interest rate decision, and bond yields continue to rise, investment management consultant MATTHEW FEARGRIEVE considers some low-cost mutual funds and ETFs to provide some inflation-proof padding to your ISA and investment portfolios.

As we write, the Federal Open Market Committee (FOMC) has concluded its March 16-17 policy meeting. The Fed’s main objective has been to convince consumers and financial markets that a post-pandemic economic recovery is not guaranteed, and that interest rates in the US are to stay on the floor, which is where they have been since the start of the pandemic. Indeed, the Fed indicates that it isn’t expecting a rate increase until 2023 at the earliest.


Inflation and why it matters


The rate of inflation in the US is still well sort of the Fed’s indicated rate of 2%. But there is a real and growing concern that global stimulus packages, coupled with the pent-up demand from locked-down consumers, could hike up the cost of living significantly, which will precipitate a period of price inflation.


The Fed sees inflation running to 2.4% this year, ahead of its previous estimate of 1.8%.


So what should I do with my Portfolio?


In the first part of this article, we explained the relationship between inflation and bond yields, and why bond yields are currently rising.


In the second part of this article, we discussed the impact that an inflationary economic environment, together with rising bond yields, will have on your personal investment portfolio and identified some market trends that should shape your portfolio as we move into post-pandemic (and, possibly, inflationary) phase.


In this, the third and final part, we consider how those market trends can translate into investments for your ISA or other investment portfolio. We will table some mutual funds and ETFs you might consider for inclusion in your portfolio, as a means of providing some protection against inflation (if it comes).


When thinking about rising bond yields and the prospect of inflation, it is necessary as usual to consider separately the “bonds” (debt) and the “equities” (stocks and shares) components of your portfolio.


Bonds


Given the uncertainties in the bond markets (with some commentators predicting that the yield on 10-year US Treasury bonds will break through 2.25% this year, which is sky-high and which will depress bond prices - click here to learn why), you would be forgiven for thinking about moving some of your bond and fixed-income investments into cash, whilst waiting to see where longer-term bond rates end up.


Whilst uncertainties in the bond (and equity) markets might argue in favour of increasing your cash reserve to between 10% to 17% of the overall value of your portfolio, you can are by no means precluded from buying bond funds for your portfolio. Just make sure that you follow these two, protective rules.


First, avoid bonds with longer maturities, say, anything over three to five years. Bonds with longer maturities are more exposed to changes in interest rates, meaning they have more to lose if rates rise (which they invariably do, once inflation kicks in).


Secondly: use inflation-linked bonds (like TIPS) as a way of keeping your money in fixed income whilst protecting against inflation risks. The coupon offered on these bonds is linked to a rate of inflation, meaning the interest they pay rises as inflation goes up.


What follows are some low cost, exchange traded funds (ETFs) that provide index-linked exposure to government debt in return for an acceptably-low annual charge. Please note that these ETFs are ideas only, not recommendations or formal investment advice.


The iShares USD TIPS 0-5 UCITS ETF (GBP Hedged) combines both protections, by investing in index-linked US Treasury Bonds with short maturities (0-5 years). With a respectable performance history, a low buy price (around £5 per unit at time of writing) and an annual charge of 0.12%, this product allows you to include bonds in your portfolio and hedge against possible losses due to inflation.


A suitable bedfellow for this fund could be the Lyxor Core UK Government Inflation Linked Bond UCITS ETF, providing access to UK government bonds with in-built protection against inflation, for an OCF of just 0.07% (upside) and a rather high per-unit buy price of around £20 (downside).


Finally, a fund providing access to global government bonds with index-linked protection against inflationary pressure: the iShares Global Inflation Linked Government Bond UCITS ETF, a fund with a Morningstar rating of Four Stars, and an OCF of just 0.20%.


Equities


Inflation is not necessarily a bad thing for all stocks. Indeed, it has different implications for different types equities. A big consequence of inflation (or the fear thereof) is to drive in the realm of investor sentiment a rotation out of (high-value) growth stocks into (cheaper and more cyclical) value stocks.


Your equity fund choices for your portfolio should reflect this rotation. This shift favours real assets such as commodities, infrastructure and gold, all of which are expected to do well in the reflationary phase that is accompanying the global vaccine roll-out.


The kinds of stocks which have benefited so much from the a low-rate, low-inflation environment that we have had for some time – the prime example being Big Tech- are now expected to perform less well than they did in 2020.


You medium-term objective will be to achieve a balanced, diversified portfolio of quality liquid assets with a bias towards equities, which is where growth will be found, as opposed to bonds. So the traditional 60/40 equity/bond split - and variations thereof - will need to be kept under active review, and fearlessly challenged when the capital growth of your portfolio requires.


So: in which equity asset classes is growth to be found?


Commodities


Commodities historically outperform when inflation kicks in. Their relationship is not clear cut though. Rising commodity prices tend to be both a cause and a reflection of inflation. Commodity producers often raise their prices in line with inflation because their cost of production goes up, in turn exacerbating those rises.


The Lazard Commodities fund tracks the Bloomberg Commodity Total Return Index, with most of its exposure to blue chip gold, gas and agricultural producers and processers in the US and the UK. The fund is structured as a Dublin OEIC and this entails higher fees: an annual charge of 0.50% together with a per-transaction cost of 0.48%, which will be a turn-off for some investors.


Infrastructure & Property


Asset classes infrastructure and property often do well in times of inflation. Infrastructure assets have explicit linkage to inflation, and the relationship of infrastructure to property is instructive: as prices rise, so do building costs, and therefore, so do property prices.


The Legg Mason Clearbridge Global Infrastructure Income fund is rated with Five Stars by Morningstar but we feel its five-year performance doesn't justify its 0.92 annual charge plus whopping 0.62 per-transaction cost.


A cheaper alternative to give your portfolio indirect exposure to international property, and with respectable five year performance, is BlackRock's iShares Global Property Securities Equity Index Fund, rated with three Stars by Morningstar and priced at an attractive 0.18% per year with an additional 0.08% per-transaction fee. The fund is an ETF that tracks the FTSE EPRA Nareit Custom Developed Index, which provides you with proxy access to global property companies, just over the majority of which are in the US, with the remainder being fairly evenly split across Canada, Europe (including the UK), MENA, Asia Pacific (including Japan) and Australia.


With solid five-year performance that is materially in excess of the index performance, this tracker is a good, inexpensive buy that will let your portfolio benefit from an upturn in global property prices hinged on post-pandemic recovery and/or an inflationary environment.


Gold


Many of us will have bought some exposure to gold miners and gold producers for our portfolios at the start of the pandemic, given that gold is the traditional flight-to-safety asset when equity markets are turbulent. When inflation is driven by rising commodity prices, gold tends to do well.


We explored the fortunes of gold prices over 2020, and their unlikely "safe haven" pairing with Bitcoin in our earlier blog here.


Ninety One Global Gold 1 Acc is a globally invested OEIC owning shares of companies involved in gold mining and in related derivatives, is another holding, and is up 37% over 12 months.


A well-performing catch-all for gold and precious metals with Golden Prospect Precious Metals, which has an underlying investment split of 66% gold, and 25% silver, where producers are 64% and developers 24%.


A higher-costing but still decent alternative with reasonable performance is the WisdomTree Physical Gold ETF, which has an annual charge of 0.39%.


Emerging Markets


Opinion is divided on the attractiveness of emerging markets. A more positive view is that emerging market economies are a good indirect bet as they benefit from the positive pulse of increased spending by the US consumer.


A regional, emerging market fund with a nice infusion of sustainability is the Stewart Investors Asia Pacific Leaders Sustainability Fund, which allocates the majority positions in the Emerging Asia sector.


An alternative providing broad indirect access to emerging markets is the Artemis Global Emerging Markets fund. Like the Stewart fund, this has the majority of its exposure to the Emerging Asia zone, but has additionally positions in Africa, Latin America and Emerging Europe.


Blended funds


For investors cautious about the prospects for recovery and for rising inflation, and wanting the convenience of a blended fund, the AJ Bell Personal Assets Trust offers a suitably cautious approach with some inbuilt inflation-proofing: it layers a 12% exposure to gold and a 35% allocation to index-linked bonds over a core 40% exposure to high-quality equities like Microsoft, Diageo and Unilever.


The convenience of having a one-stop-shop fund like this comes at a price however: a relatively stiff OCF of 0.86% per annum, but still not bad for coming in at under 1.00% per year.


Going forward


Remember, inflation isn’t with us just yet, and market views as to when, or if, it will come remain mixed. But with a few easy, low-cost adjustments, you can provide your portfolio with some insurance against rising asset prices.


For some Ideas for your ISA in a post-pandemic recovery phase (reflationary or inflationary) click here for our earlier blog on how to make the most of your 2020/21 tax allowances before the end of the tax year on 5 April.


For our 2021 Investment Outlook across all the major asset classes, click here.



MATTHEW FEARGRIEVE is an investment management consultant. You can read his investing blog here and see his Twitter feed here.


Matthew Feargrieve, investment management consultant

IMPORTANT: the views expressed in this article are opinion only, and are not intended to be relied upon as financial advice or treated as a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.

Drop Matthew Feargrieve a Line

at www.feargrieve.co.uk

London, England

© 2020 by Matthew Feargrieve.