How your financial advisor can help you buffer your portfolio against inflation

The 2021 investment debate centred on inflation; we’re now seeing interest rates as the topic of conversation, more so in global markets: Wendy Myers of PSG Wealth.

CIARAN RYAN: There’s been considerable debate recently about the impact of inflation and increasing interest rates on equity portfolios. Investors are understandably concerned that rising inflation will impact not only their monthly spending, but also their portfolios.

Joining us to explore this is Wendy Myers, head of securities at PSG Wealth. Hi Wendy, good to have you back on again. What should investors be aware of when considering these factors against the backdrop of equity returns? Of course I’m talking about inflation and interest rates.

WENDY MYERS: Yes. Thanks, Ciaran, for having me on the show again today.

I think in theory equities offer a buffer against inflation. Obviously we know that a rise in prices should correspond to a rise in revenue, and naturally this bolsters share prices. This could be offset, however, by a contraction in profit margins because naturally company input costs will also increase, driven by inflation.

But in practice we find that the impact on earnings is varied, according to different economic sectors. It’s the ability of those sectors to pass on higher input costs to consumers [that] really sets those sectors up for success, being able to buffer inflationary impacts. So really what we find, in summary, if we look across theory and across practice, as long as revenue increases faster than the input costs then naturally profit margins will increase and translate to greater nominal earnings.

But it’s important to note that consumers will be under pressure when there are inflationary prices and [that] could result in consumers buying fewer products, or at the very least curtail some of their spending. That would obviously see profits declining for those companies.

CIARAN RYAN: I think people would be quite keen to hear whether there are certain sectors that are more resilient at times like this [and] are a hedge against inflation? What are the sectors that we should be looking at, or the asset classes?

WENDY MYERS: There [are] a few sectors that we’ve seen, certainly in the past, that have performed well in the inflationary environment. The energy sector is an example; remember the energy sectors made up of oil and fuel companies typically have beaten inflation 71% of the time – which is quite an impressive statistic – and have delivered an annual real return. So, after accounting for inflation of 9% per annum on average, typically the revenues of these types of companies are tied to energy prices, which is a key driver of inflationary indices. That’s why that sector in particular performs well.

I think also another sector to consider is the real estate investment trusts, or ‘Reits’. So they typically have outperformed inflation 67% of the time. They’ve posted an average real return of, okay, only 4.7%, but it’s at least a positive real return. To explain what a Reit is, we all know that it’s a real estate asset. It provides a partial inflationary hedge; it acts as a pass-through of price increases, because those price increases in rental contracts and properties get passed on to the tenant, and that’s how that sector is able to factor in those increases.

Another sector to consider is on the information technology [IT] side. These stocks are likely to suffer even more, because their promised future growth in profits is likely to be a lot less valuable in today’s money terms. The bulk of their cash flows are expected to arrive in the distant future, and obviously inflation corrodes those returns.

[As for] financials, I think banks on the other hand have performed comparatively better than the IT sector as their cash flows tend to be more concentrated in the short term.

So I think if we summarise the various sectors, where there are inflationary pressures – and we are starting to see that inflationary uptick continue – equity prices fundamentally will remain volatile. But certain of the sectors will be able to absorb the impact a lot better than others, so I think it’s extremely important to be very careful and deliberate about where you place your money in this environment.

CIARAN RYAN: Okay. So the energy sector, [and you] certainly want to look at real estate investment trusts, another one. Information technology – not so good as an inflation hedge, apparently.

Is that a pretty good summary of the sectors – the good and the bad?

WENDY MYERS: Yes, I think that’s a perfect summary, Ciaran. Thanks.

CIARAN RYAN: Okay. So we’ve talked about inflation. Let’s talk about interest rates and the impact that’s going to have on equity portfolios, because worldwide we are really at the start of an interest rate …

WENDY MYERS: … increasing cycle.

CIARAN RYAN: Yes, the increasing cycle. How is that going to impact portfolios?

WENDY MYERS: I think we all know that a rise in interest rates negatively impacts equity prices as both businesses and consumers cut back on spend. That causes earnings to fall and then naturally the equity prices pull back.

So when we consider both inflation and interest and their impact on 2022 equity returns, you can understand why portfolios are going to be extremely volatile.

I think it’s important to note that the 2021 investment debate centred around inflation; what we are seeing now is interest rates are definitely the topic of conversation, more so in global markets, where inflation has been benign for quite some time. As a result, equity prices pre-2022 have been extremely robust and investors have enjoyed strong returns in that market.

Now, with interest rates on the rise, we are expecting a contraction of those equity returns and hence an increase in the volatility, so investors have to be extremely cautious when deciding where to place their money.

But in summary, it’s important to discuss your portfolio construction, because we’ve learnt about the various sectors that can be positive from an investing perspective in an inflation economy, and those where your returns could be at risk. It’s important to discuss the portfolio construction with your financial advisor, who is best placed to assist you in really constructing a diversified portfolio which takes into account volatility, and sets you up better for success in the future.

And then I think in closing, Ciaran, it’s important to take a long-term view when investing. That’s certainly how we view the investing landscape at PSG.

CIARAN RYAN: Exactly. We are getting inundated with stories of people in the Covid crash of March 2020 selling their portfolios, which of course rebounded within two weeks. It just shows you the mistakes that can be made by chopping and changing your portfolio because of events that seem dramatic at the time, but in retrospect are not. Is that correct?

WENDY MYERS: Yes. In fact, we often say investors should be cautious of trying to chase performance. I think certainly as much as they panic on the down, [they] then battle to know when to get in and they believe that the past performance of a share is reflective of where it’s going to be in the future – which is not necessarily the case.

CIARAN RYAN: Okay. Wendy Myers is head of securities at PSG Wealth. We’re going to leave it there. Thanks so much, Wendy, for coming on.

WENDY MYERS: Thank you very much for having me on your show today, Ciaran.

Brought to you by PSG Wealth.

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