Inflation worldwide is on the rise, driven by fuel price hikes, the ongoing energy crisis and rising food prices. Locally, inflation is at its highest level in five years. The sharp rise in inflation has seen central banks around the globe responding by hiking interest rates. Rising interest rates are impacting the performance of financial assets across the board, but in addition shifting consumer spending patterns and preferences due to higher inflation also hold distinct implications for the performance of equity portfolios.
PSG Wealth’s Head of Securities, Wendy Myers highlights that the impact on earnings will be different for different market sectors, and hence investors can expect divergent returns from their equity portfolios. In addition, markets are likely to be volatile as they continue to digest new information about inflation and economic growth. Within this context, investors need to be particularly discerning when it comes to selecting how to position their share portfolios. This is where she sees financial advisers adding value to their clients, not only by helping to manage investors behaviour, but also through their understanding of the impact of inflation on various market sectors and asset classes.
According to Myers, rising inflation sets in motion a chain of events with the knock-on effect being most visible in rising interest rates, which has a negative impact on equity prices due to both businesses and consumers cutting back on spending. In turn, this causes earnings to fall, and equity prices naturally pull back. However, she cautions against falling prey to the negative news and emotional responses that often surrounds reporting on inflationary pressures in the media, as equities remain the asset class most likely to outperform inflation in the long run.
Myers advocates for a balanced outlook and following a diversified approach, as – with the guidance of an experienced professional, it is possible to tilt portfolios to withstand the impact of inflation better. For example, she advocates an approach that considers the addition of investment in sectors like energy and real estate, which could help to buffer portfolios against the effects of inflation. Finding the sectors more likely to benefit from rising inflation will be key to constructing resilient portfolios.
As an example, the energy sector, which is predominantly made up of oil and fuel companies, has typically beaten inflation 71% of the time and delivered an annualised real return after considering inflation. “The revenues of these energy companies increase as energy prices go up, which is why the sector in particular, performs well,” argued Myers.
Real estate investment trusts (REITs) have also typically outperformed inflation 67% of the time with an average real return of 4.7%. Expanding on how the real estate industry responds to rises in inflation, Myers explained that REITs provide a partial inflationary hedge that “acts as a pass-through of price increases,” because those price increases in rental contracts and properties are passed on to the tenants. In so doing, the sector is able to factor in the increases.
In contrast, she expects that the Information Technology (IT) sector will take a knock because its estimated future growth in profits is likely to be a lot less valuable in today’s monetary terms. This is because the majority of the cashflows of these companies is expected to be realised in the distant future. Inflation will therefore have a corrosive effect on these returns.
Thus, while the persistent uptick in inflation is likely to mean that equity prices will remain volatile, certain sectors will be better at absorbing the impact than others. For this reason, Myers advises investors to be “careful and deliberate” about where they place their money in this environment.
Concluding her thoughts on this topic, Myers suggests that: “We often say investors should be cautious of trying to chase performance. I think certainly as much as they panic on the down, investors also battle to know when to return to the market and they believe that the past performance of a share is reflective of its likely future performance – which is not necessarily the case. As always, diversification and seeking expert advice before executing big changes to your portfolio, is key.”