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Overlooked equities may protect best.

Byline: ANDREW MILLER

INFLATION has been grabbing investors' attention over the past few weeks. There remains little doubt that the global recovery debate has moved on.

But with inflation already a concern in emerging economies, the belief - becoming entrenched into markets - is that it is a matter of if, not when, inflation will return to developed economies.

The release of the Inflation Report last week has shown that the Bank of England has revised up its inflation forecast a little, and slightly lowered its near-term growth projection. This suggests that the growth-inflation trade off has somewhat worsened.

In addition to this, the report also noted that "inflation is more likely to be above target than below it at the two-year point" if the official rate remains unchanged.

Although we do not yet envisage a more significant upturn in inflation, for those who do, it may be appropriate to consider some inflation-hedging instruments within portfolios.

There is no "silver bullet" in the investment world that can provide a perfect hedge against inflation.

Commodities are often cited as a solution, but here the track record is not perfect. Furthermore, index-linked government bonds are regularly touted as the answer but again, while they may protect the purchasing power of a particular portfolio of bonds (if held to maturity), they are unable to hedge a balanced portfolio.

The most often overlooked asset class that can potentially protect against inflation is in fact equities.

It is well-known that equity valuations tend to suffer when inflation is high, thus negating the nominal increase in earnings that the corporate sector enjoys. That said, there have been periods when equity markets have provided a reasonably good hedge against inflation.

In terms of the correlation between equity markets and the level of inflation in the US, for example, on a historical basis, we found that this relationship is not stable, even though there have been a few key periods when the correlation between equity markets and inflation increased as the latter rose.

Although having exposure to equities as a whole could provide a partial hedge against inflation, we would suggest that more targeted exposure could be more effective.

It is possible to identify companies that have an element of genuine "pricing power" - which can help them mitigate or even benefit from the effects of inflation.

These companies are able to pass on rising costs to their customers, and may therefore benefit from rising prices. They can include industry specialists, global luxury goods retailers or utilities firms.

Andrew Miller is regional office head of Barclays Wealth in Newcastle.
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Publication:The Journal (Newcastle, England)
Date:Feb 23, 2011
Words:428
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