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Coping mechanisms

You can do much to protect a portfolio against rising inflation and understanding investment strategy is key

It is not enough to look at performance alone if you hope to understand how a fund is likely to perform. You need to look at the risks being taken to generate returns, examine the correlations with the major asset classes and get to grips with how the fund is managed. And current economic conditions mean a fund’s ability to cope with inflation must now be added to that checklist.

Consumer price inflation has reached an annual rate of 4.5 per cent but interest rates remain at emergency levels of 0.5 per cent. Whether the Bank of England is engineering higher inflation as a solution to the debt crisis or is simply slow to act, the upshot is much the same for investors and it is time to check your portfolio’s inflation shock absorbers.

The effect of inflation is subtle but pervasive. As prices rise, the purchasing power of your savings falls. It is a particular problem for anyone on a fixed income or whose income is not indexed to inflation.

But there are things we can do to prepare a portfolio. The first is to look at the fixed-income component. Conven-tional bonds with fixed coup-ons are perhaps the most vulnerable part of a portfolio, so a good starting point would be to review your exposure.

One option might be to look at index-linked bonds, design-ed to help investors preserve the real value of their investments. There might be limited potential for outperformance but they should provide a degree of protection.

Specialist fixed-income investments such as corporate bonds or absolute-return fixed-income funds are also worth considering. The performance of corporate bonds tends to be allied to the that of the issuing company. They may not be a route to big returns in an environment of rising inflation but they should prove more defensive than conventional bonds.

Absolute-return fixed-income offers a different route. With flexibility and often the ability to take negative duration positions and profit from rising bond markets, these funds can provide capital returns in excess of inflation.

Unlike conventional bonds, equities are real assets. All else being equal, a share in a com-pany with pricing power and the ability to keep control of costs should retain its value and investing in such companies can be a good strategy when prices are rising. A manager with sufficient investment flexibility and the right strategy should adjust to the changing environment.

Only if you understand your equity manager’s investment strategy can you predict how that fund is likely to perform in a period of rising inflation.
We have only talked about UK equities but emerging markets can provide diversification and a valuable source of capital returns. Asia’s inflation problem has been widely reported but central banks in the region, including China, are much further along the path of monetary tightening than in the West.

We could find ourselves in the position where interest rates are still being raised to combat inflation here, while being cut in emerging Asia, providing a more favourable environment for economic and corporate profits growth, as well as the potential for currency appreciation.
Finally, we must not over-look other real assets, such as global resources, agriculture and even property.

Liquidity can be an issue with property but oil and gas prices depend more on geo-politics than fundamentals.

However, interest has grown in agricultural commodities, attracted by rising demand and relatively static supply.

One of the main sources of inflation has been rising food prices and investing in agricultural commodities or related equities could be a good way of preparing your portfolio for tougher times.

Ian Pascal is head of marketing & communications at Baring Asset Management

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