Inflation can lift prospects for investors

INFLATION at 3.7 per cent and still rising is emerging as one of the big investment issues of 2011. But what does it mean for investors?

They should recognise that some businesses will lose out due to inflation, and think again about the apparent safety of bonds. But for portfolios focused on global growth, and businesses that can pass on costs, inflation should be good news.

Only those with long memories will fear the impact it can make on investments. In the 1970s, inflation destroyed many businesses and portfolios. But now most commentators think it will give a boost to shares and should be welcomed by investors. How should investors react?

The focus on the UK consumer prices index (CPI) over the past 12 months means little attention is being given to the 4.8 per cent rise in the more traditional retail prices index (RPI). Further costs are on their way, with the VAT rise and a pick-up in food and energy prices. Other rises in tax and national insurance may also be passed on to the consumer. It may not be so easy to tame inflation once it is loose.

Already it means the low interest received on bank savings deposits is actually a negative real rate of return. Maintaining the buying power of money will be difficult in deposits, or even in gilts or fixed income funds.

Indeed, many investors have opted for additional risk in funds that appear to offer higher returns from bonds and other fixed income investments. These typically take on some increased risk by investing in sovereign and company debt that pays more, but has greater risk of loss than gilts. Whether the extra short-term returns from these investments compensate for the additional risk or the difficulty in dealing has yet to be seen.

So far, the flow has largely been one-way into these funds, but there could be problems if that turns into a rush to exit. It is not always as easy to get in and out of the underlying debt instruments as it is to buy into the funds. If there was a flood of redemptions as investors recognise the negative real returns on bond funds, there could be a delay in repayment. The bond bubble has been driven by easy money and low interest rates, but could be pricked by inflation. After 2008, bond funds looked like they offered safety with higher rewards, but the prevailing wisdom could easily reverse.

Whether inflation should be welcomed by equity investors depends on what type of shares they hold. Inflation in the UK, US and Germany could produce surprisingly good economic growth this year. The authorities seem more concerned with unemployment than inflation, and the UK may focus on this too.

In the US, the electoral cycle is also a factor, with President Barack Obama seeking to boost the economy this year in the run-up to the 2012 election. In Germany, growth of 5 per cent - half of that coming from inflation - could help to bail out some of the Eurozone problems. Spain and Italy may avert a crisis. That scenario would be good for some financial shares. There is little political incentive around the world - other than in China - to constrain inflation; the surprise could be on the upside.

However, the biggest winners from much stronger global growth would be the resource and industrial sectors. Although unemployment is high in the West, there are some real shortages of skills and materials. This suggests that tax rises and austerity measures may not arrest overall inflation. In the UK we must accept that many of the commodities and foods we import have prices set by international markets. Higher interest rates may force us to consume less, but they will not drive down world prices.

What would be at risk in the stock market are the sectors where costs cannot be passed on so readily. Retailers and pubs, for example, are seeing sharp rises in some costs, but meeting consumer resistance. These sectors could be losers from this bout of inflation. Profit margins would be squeezed as consumer-oriented businesses are forced to absorb some of their rising input costs.

And some defensive sectors, such as pharmaceuticals, will not share in global growth or industrial recovery to the same extent. Many investment analysts believe ratings have fallen too far for stocks such as GlaxoSmithKline, but it is hard to see its attractions if global growth remains strong. It is tempting to look at shares that have been left behind and buy underperforming, supposedly quality businesses, but cyclical shares would be the winners of 2011, despite the gains they have already made.

This further pick-up in business confidence could spur more takeover bids. Mergers give cost-cutting opportunities and there is cash on the balance sheets of major companies looking for targets. Favoured sectors could include chemicals, junior oils and engineers. And, despite the pressures on consumers, brands such as Burberry, SuperGroup and Mulberry should be able to hold profit margins and maintain strong growth.

Only in the UK does inflation show signs of being out of control. The Bank of England has been surprised by inflation for more than a year, and may be forced into a token rise in interest rates just to regain credibility. So far, average pay is not growing strongly, and international investors have retained confidence in gilts and the pound.

Colin McLean is managing director of SVM Asset Management