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As well as being worried about a slowdown in economic growth, investors are increasingly uneasy about rising prices. Strong growth in the world’s developing economies has created huge demand for building materials and agricultural and energy commodities, pushing their prices higher.

This has fed through to global inflation, which has started to rise from historically low levels. The time has come for investors to consider whether their portfolios are properly positioned in this environment.

Even though the pace of economic growth will probably ease this year as a result of the disruption of the credit markets, demand from emerging economies, particularly China, is likely to keep commodity prices high. Central banks face the difficult challenge of balancing reduced economic activity with the risks of higher inflation. In developing countries, monetary policy may tighten, with interest rates rising, while the monetary authorities in the West are under pressure to reduce rates. This raises the spectre of a policy error, with potentially serious consequences.

Inflation is sometimes called the enemy of bond market investing, as rising prices erode the value of the returns from fixed-interest securities. In theory, equity investment should be protected from rising prices since revenues and earnings should rise at similar rates but inflation still poses a threat.

One obvious way of protecting against inflation is to hold inflation-protected bonds, where the interest payments and principal are linked to the inflation index.

A modest allocation to these instruments may be a sensible way to protect a portfolio against inflation but we currently see little value in Government bonds after the recent strength of the fixed-interest markets. In particular, the UK index-linked bond market currently appears to offer the prospect of very low long-term returns relative to European index-linked bond markets.

Over the long term, we see more potential in equity markets. In particular, we believe the long-term case for many of the world’s emerging markets remains intact, as does the case for companies involved in the production or distribution of commodities.

We would, however, favour emerging countries with healthy economic fundamentals and credible monetary and fiscal policies. We believe these have the option of tackling inflation through monetary tightening and currency appreciation and that selected companies in these countries offer excellent protection against the risk of inflation.

This group includes the resource-rich Middle East and Russia and Latin America, which is well positioned to benefit from growing demand for food.

We are also confident that the long-term case for investing in Asia remains in place. China is expected to continue on its path of industrialisation and urbanisation, creating an environment where earnings can grow even if commodity prices rise.

Property has traditionally been a sensible choice for investors concerned about inflation, particularly where rental yields are subject to regular review. However, problems in the financial sector have started to affect the property markets in the US and UK, making us cautious about the prospects for this asset class at present. Instead, we would consider selected property markets in Europe and Asia, where the outlook is more buoyant. These markets could add useful diversification to a portfolio as well as a degree of inflation protection.

Another method of adding diversification while still aiming for returns in excess of inflation could be an allocation to hedge funds. Event-driven strategies can be positioned to benefit from rising prices while long/short strategies have the potential to short companies likely to perform badly in an infla-tionary environment.

Another possibility is an investment in funds which invest directly in commodities although this can be a rather specialist area.

Ian Pascal is marketing director at Baring Asset Management


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