Can you ground your investments as inflation takes off?

Inflation is taking off as economies surge out of lockdown and supply bottlenecks emerge. Russia’s invasion of Ukraine, meanwhile, has exacerbated energy shortages and sent the price of oil and gas soaring.

While a return to 1970s levels is unlikely, we anticipate that inflation will remain above central bank targets for some time. Higher prices are inevitably squeezing disposable incomes and leading to questions about whether the transition to net zero can be sustained.

That begs the question: which assets provide the best shield against inflation, and what impact will inflation have on the drive towards a low-carbon economy? As ever, there are answers to these questions but they are not obvious and require further analysis…

Inflation has emerged as a significant challenge – even, perhaps, the key challenge – facing investors around the world this year, with all major regions affected to a varying degree. In February, inflation soared to a more than 40-year high in the US¹ and an all-time high in the eurozone.²

Supply-and-demand imbalances caused by pandemic-related lockdowns of factories and other key economic sectors are the principal cause of inflation. As economies emerge from lockdown, pent-up demand has exploded, but it is taking time for supply chains to return to normal.

Russia’s invasion of Ukraine in February has exacerbated shortages of energy, further fuelling inflation. Russia is a significant exporter of oil and gas, particularly to Western Europe, which is under pressure to curb imports from Moscow.³

The International Energy Agency has also signalled that energy prices will rise further in the months ahead, given low inventories of oil.⁴

Furthermore, hikes in the cost of fertilisers are driving up food prices worldwide. Russia is a key exporter of fertilisers – and grain – and the Ukraine war and associated sanctions are disrupting supplies. Higher energy costs are also feeding the surge in fertiliser costs.⁵

We think there are good reasons to believe that the current spike in inflation is unlikely to prove temporary. However, inflation will probably not return to the high levels seen in the 1970s, partly because central bankers have learnt from the mistakes of that decade.⁶

Nevertheless, there is a risk that inflation will remain above central bank targets in developed economies in both the near and longer term.⁶

There are various catalysts that suggest inflation will remain elevated over the long term. These include demographics, politics, protectionism, fiscal policies, the green transition and an inflation tax on debt.⁶

In terms of debt, there is today – and unlike the Global Financial Crisis of 2007-08 – no appetite for austerity. High debt levels will also incentivise policymakers to have a higher tolerance for inflation.⁶

Global demographics are changing slowly as populations age around the world, including in China, where wages have also risen sharply.⁶

Globalisation is also retreating as companies rethink supply chains in the wake of the pandemic, potentially raising costs.⁶

Growing concern about inequality, heightened by the pandemic, is likely to drive demands for greater redistributive policies and higher wages.⁶

The green transition could also prove inflationary as higher carbon prices will be required to incentivise the switch to greener sources of energy.⁶

Central banks have signalled that interest rates will rise significantly over the coming year. The banks also intend to rein in the accommodative monetary policies used to stimulate growth in the wake of the pandemic in an effort to contain inflation.⁷

At the same time, higher inflation – unless accompanied by real increases in wages – will weigh on disposable income, further undermining global growth prospects.

In the longer term, higher inflation could also weigh on consumers and investors as governments resort to financial repression to reduce the real cost of servicing their vast debts, with inflation effectively acting as a tax on investors.⁶

During the past decade of low inflation, investors in mixed portfolios of equities and fixed income did not need to worry about the impact of inflation.⁶

Investors should consider incorporating inflation-sensitive asset classes into their allocations. Inflation is the principal enemy of fixed income. However, certain sectors – such as inflation-linked bonds – can compensate investors for inflation. Bonds with an attractive yield can also help.⁶

Real estate can give you a competitive advantage over other asset classes, as rental values are often indexed to inflation.⁸ Sectors driven by strong demand (and hence strong pricing) should be particularly well placed to offset potential losses from inflation.⁹

Equities require a similarly discriminatory approach: companies with pricing power and/or capital-light business models have the best inflation-protection characteristics.⁶

Commodities have traditionally performed best in a higher-inflation scenario. Gold is probably the world’s most well-established safe-haven store of value.⁶

Higher oil and gas prices should hasten the transition to sustainable sources of fuel such as wind and solar power by making investment in these green alternatives more viable.¹⁰ The rising cost of oil and gas also boosts the competitiveness of renewables, which already tend to have lower marginal costs than fossil fuels.

Pressure to act on climate change will remain intense. Germany recently announced a raft of new measures to further boost renewable power, and other countries – certainly in Europe – are likely to follow suit given the pressure to reduce the Continent’s energy dependence on Russia.¹¹

Overall, we believe demand for sustainable assets will remain intense and they will provide a good hedge against inflation.

At BNP Paribas Asset Management, our experienced team investigates how inflation affects each and every asset class. We use our knowledge and skills to identify the most resilient sectors and uncover the highest-quality opportunities that can best shield investors from the worst ravages of inflation and drive long-term returns. We also believe higher energy prices should boost sustainable assets – such as renewables – and are committed to using our influence to drive investment in this area.