How expert investors react when faced with high inflation

A global surge in prices has knocked the equity markets off their stride and put many investors on the defensive, yet there is still value to be found


Floor trading at German Stock Exchange in Frankfurt, Germany, 08 May 2014, on the day of the monthly board meeting and press conference by European Central Bank president Mario Draghi. The ECB has decided to keep its interest rates unchanged, and Draghi stated that inflation expectations for the euro area over the medium to long term remain below 2 percent as aimed by the ECB. (Photo by Horacio Villalobos/Corbis via Getty Images)

The doyen of astute investment, Warren Buffett, has been warning about the return of high inflation since the bad old days of the 1980s, describing it as a “cruel tax” that “swindles almost everyone”. Despite this, the recent surge in prices hasn’t deterred him from buying shares. Even as the US inflation rate hit a 40-year high and stock markets fell sharply this year, the venerable chairman and CEO of Berkshire Hathaway ploughed more than $40bn (£33bn) into equities.

Amid a surge in global commodity prices, Buffett has focused on oil and gas stocks. He’s also snapped up shares in tech giants Apple and HP, both of which fit his philosophy of investing in good-value firms that make products that are always likely to be sound performers, regardless of whatever economic headwinds may be blowing. 

As food, fuel and energy prices have rocketed since Russia invaded Ukraine in February, the markets have been shaken, obliging fund managers to adjust their trading strategies. Consumers are tightening their belts while central banks are hiking their interest rates, which is restricting growth and so increasing the risk of recession.

These conditions are spooking investors. The benchmark US stock index the S&P 500 lost about 20% of its value between January and mid-May, for instance.

Joe Little is chief global strategist at HSBC Asset Management, which is responsible for assets worth about £525bn. He says it’s “completely understandable that investors have been feeling confused and uncomfortable, given that most had ever experienced an inflation shock on the scale we’ve seen over the past 18 months. There are some significant unknowns about the economic outlook. For professional investors, this is where your investment philosophy and process really help you through the uncertainty.”

Diversification comes into its own as a protective measure during periods of high inflation, according to Little. Traditionally, investors have relied on the relative stability of bonds to balance out the riskier equities in their portfolios. But the price of bonds will fall as central banks push up their base rates further to tame inflation, so they won’t be able to fulfil their usual hedging role. Investors therefore need to look at alternatives, he says, pointing to the merits of more tangible assets such as gold and real estate. 

As for equities, investors must think even more carefully about the type of companies they buy shares in, warns Victoria Scholar, head of investment at trading platform Interactive Investor. 

“For a long time, equity market gains have been underpinned by ultra-loose global monetary policy. But the era of monetary loosening is over, which has serious implications for valuations,” she says.

Scholar believes that it’s important to differentiate between firms that can pass most of their heightened cost burden on to consumers through higher prices and so avoid margin compression (known as price makers) and those that must shoulder these extra costs themselves (price takers).

It’s completely understandable that investors have been feeling confused and uncomfortable, given that most had never experienced an inflation shock on the scale we’ve seen over the past 18 months

She cites companies in the luxury sector as examples of the former. With the “power to push up their prices without significantly diminishing demand, they could be interesting. But it’s also worth noting that we could see weaker demand if growth in the global economy – and China’s in particular – slows.” 

While debt-laden firms are most likely to struggle in the current conditions, those in certain sectors stand to benefit from rising inflation and interest rates, Scholar notes. 

“Banks, for example, tend to fare better because of improved net interest margins,” she says. “Also, a lot of the current inflation has been driven by gains in the commodities complex on the back of the war in Ukraine, so stocks in fossil fuels and mining have been achieving strong profits.” 

David Jane is multi-asset manager at Premier Miton Investors, which is responsible for about £14bn of assets. He reports that his firm is becoming increasingly concerned about the risk of recession and is adapting its approach accordingly. 

“During a period of high inflation we would expect interest rates to be rising over that time. This means in our fixed-income exposure we’d avoid longer-dated bonds especially,” he says. That’s because high inflation tends to erode the purchasing power of a bond’s future cash flows.

With respect to equities, Jane believes that companies with “real assets” and suppliers of basic raw materials are likely to do better. For that reason, his firm prefers undervalued stocks to growth stocks (comparatively risky punts in firms that are expected to outperform the market average).

At HSBC, Little is more sanguine about the outlook. He believes that the global economy will probably avoid the recession that has been predicted in some quarters. 

“While we think that the ‘stagflation’ tone of weak GDP growth and high inflation will continue for a while, we do see some encouraging signs. Supply chain bottlenecks are beginning to ease, for instance. Our view is that inflation has peaked and will gradually cool off over the next six to nine months,” Little says. “It could be that stock market behaviour will look rather different in the second half of this year.”

For now, though, HSBC’s approach to equities has become more selective, focusing on commodity-linked stocks and price makers. Little also favours undervalued and short-duration cash flow stocks – which are held for weeks or even days – over riskier growth stocks.

Scholar believes that volatility in the equity markets will last the whole year, but she is confident that the tightening of monetary policy by central banks should ease most people’s fears that inflation might spiral out of control. 

She adds that a common mistake is for investors to “hit the panic button” by liquidating their positions and heading for the exit at times of great uncertainty. Given that high inflation erodes the value of money in the bank, keeping its real rate of return “very much still negative” despite recent interest rate rises, “remaining invested appears to be the best strategy in the long run”.