How to protect your portfolio and goals from runaway inflation

Though not a levy per se, inflation is the worst kind of tax as it often goes unnoticed. High inflation has gripped the global economy, including countries like the US, UK and India, with rising commodity prices and an unprecedented amount of stimulus money sloshing around in these economies.

How does an investor safeguard her portfolio and goals from high inflation? Essentially, there are two broad ways.

Outpacing inflation is about positioning your portfolio to grow bigger over a while and deliver returns that exceed the inflation rate. If your goal is to build a corpus for future spending and the goal is at least ten years away, then this strategy works.

Hedge against inflation broadly focuses on protecting your near-term consumption from rising inflation. It is applicable especially if you are nearing retirement or have short-term goals, thereby giving little leeway to realign your portfolio or improve earnings.

Also read: How to manage your portfolio in times of high inflation

First, let’s look at ways to outpace inflation

During inflation, input prices usually go up for businesses. If a company has pricing power, it passes on the higher cost to its customers and improves its topline. Even better, if they innovate to fight costs and become productive, their profits improve.

Also, some businesses in the commodities, fast-moving consumer goods and energy space tend to do well during periods of high inflation. Their stocks are therefore the best hedge against inflation. A diversified equity portfolio manager usually shuffles stock holdings periodically to capitalise on these opportunities.

Persistently high inflation impacts stock markets negatively, albeit with a lag. For instance, in 2008-09 and 2009-10, consumer inflation was upwards of 10 percent and in 2010-11, the market posted a negative 27 percent. This was the case in 2012-13 and 2013-14 too when inflation was in double digits.

So, while businesses benefit in the short run from the price increase, in the long run persistently high inflation also impacts consumer demand and pulls down business revenues.

What is encouraging, though, is that equities across the world have historically outperformed inflation over the long term. Long-term annual returns for the BSE Sensex have been 12-16 percent against the long-term average CPI inflation of 6-7 percent. It translates into a 6-9 percent real return on investments for equity investors.

Don’t keep too much cash on the sidelines, especially during times of inflation. After building an emergency fund, scout for better investment growth opportunities as otherwise, you are essentially losing your purchasing power.

Unlike in the US, inflation-indexed bonds that are inherently structured to deliver returns with rising inflation aren’t available in the Indian market.

So the better way is floating-rate bond funds. Inflation and interest rates tend to go hand-in-hand. Whenever inflation rises more than warranted, the Reserve Bank of India (RBI) increases short-term rates to control demand. The regulator has already begun the process by hiking policy repo rates by 90 basis points over two meetings.

Floating rate funds invest in bonds whose coupon rates are linked to benchmark interest rates. They tend to do well over the short term when inflation rates are higher.

So a part of retirement funds and that set aside for other short-term goals— especially those used for income generation—could be parked in these funds.

Rising inflation in the domestic economy can be a boon for international equity investors, whose foreign-currency investments get converted into more rupees. This happens because of the depreciation of the rupee against the dollar or euro.

However, investing just for currency arbitrage might not work (for instance, what if the business in a country suffers?). So, invest if you have a foreign currency-linked financial goal (like that of a child’s foreign education).

Gold is popularly considered the best hedge against inflation. However, over the years it has become too volatile and its record against inflation has been so-so. While property investors benefit from rising rent and property values during inflation, persistent inflation also hurts demand for properties as it did during the pandemic-fuelled downturn.

Any wealth creation strategy requires realistic assumptions on inflation expectations. It serves as the hurdle rate for the portfolio returns to cross in order to preserve wealth.

Consumer inflation has averaged 7 percent since the 1990s. In the past, India had witnessed high inflation due to the oil shock of 1973, when fuel prices soared by over 250 percent. With heavy dependence on oil imports, the country will continue to have its spillover effects whenever oil prices go up.

While the RBI has set its upper tolerance level at 6 percent, it might be prudent to factor in 7 percent consumer inflation while working out investment strategies.

Adequate equity exposure is the best way to protect your portfolio from high inflationary threats. Ensure you don’t keep too much cash on the sidelines either.