How to invest in a rising inflation scenario?

Inflation is the rate of price rise and erods the value of your money.

Nov 16, 2021 08:11 IST India Infoline News Service

One big challenge for investors in a rising inflation scenario is how and where to invest. Inflation is the rate of price rise and erods the value of your money. For example, if you earn 7% on a bond with 2% inflation, it is a real rate of return of 5%. However, if inflation was to go up to 5%, your real return comes down to 2%. That is why inflation matters.

How CPI and WPI inflation panned out in last 1 year

Data Source: Trading Economics

Why is the above chart significant? It is easy to get smug about falling CPI inflation because that us driven more by food prices. However, WPI inflation, also called producer inflation, is the real challenge. The last 2 years saw supply chain constraints resulting in a spike in producer inflation which is visible in metals to fuel to agricultural commodities.

If you look at the above chart, CPI inflation has come down to more manageable levels of 4.35% but WPI inflation or wholesale producer inflation still remains above 10%. That means; the high levels of WPI inflation continue to erode purchasing power and to that extent the CPI inflation does not give a proper picture of the inflation risk for investors.

How do you invest to beat high inflation?

Today, inflation in the US is above 5%, something unthinkable 2 years back. In India, the actual price rise that people are facing is substantially higher than what is shown by CPI inflation. In short, your investment strategy must have a Plan-B for higher inflation.

Notwithstanding what number your CPI inflation may show month after month, the actual inflation is much higher. Without your knowledge you may be earning negative real returns on your investments. That is why you need to have a proper plan to invest in such a way that the inflation challenge is addressed. Here is how.

1) Equity Focus – Look for capital light businesses

Why do you think sectors like FMCG and IT have continued to do well in the midst of rising inflation. One reason is that they are capital light businesses. When the real returns on your investment are falling, you cannot afford to be too heavy on capex spending. Sectors like IT and FMCG are cash flow rich businesses that do not need too much capital since their business cycles are cash-sufficient. Any stock where the company has limited capital needs and a high ROE is likely to do well in high inflation times. Tweak your holdings accordingly.

2) Equity Focus – Prefer companies that can pass on cost hikes?

This is a big advantage in a rising inflation scenario. Some of the sectors like automobiles and FMCG have been more successful in passing on the higher input costs to the end customer. Oil is another sector and the one reason why oil stocks have done well is because they can seamlessly pass on costs to the end customer. The ability to pass on cost to the end customer has its own limitations. At some point, the price hikes result in crimping demand and that is where you need to be careful as an equity investor.

3) Floating rate debt can be a good option

Let us understand the basis of this argument. The ideal approach would be to invest in Inflation-adjusted bonds where the  yields are adjusted upwards with a rise in inflation. However, those bonds are not popularly available in India. Though we do not have too many floating rate bonds, there are floating rate mutual funds which can fill the gap. Investors should look at that as a viable option to beat inflation. After all, interest rates eventually gravitate towards inflation rates.

4) Gold versus real estate: what to pick?

One common axiom is that high inflation reduces the worth of paper money and hence gold would be a natural hedge against inflation. However, gold is still a hedge and not an investment. The traditional concept of limiting your gold allocation to 12-15% of your portfolio still holds and that is a safe bet in these market conditions. Gold has been a much better hedge against global uncertainty than against persistent cost-push inflation.

What about real estate. Real estate as an investment continues to be heterogenous. However, this could be the right time to buy your own house, if you are looking for one. Interest rates are at all-time lows and builders are desperate to boost sales. What about real estate as an investment. Investors should seriously consider real estate investment trusts or REITs. These tend to pay good dividends and also appreciate in price. With realty not being fancied for a long time, REITs can be the answer.

A final thought on handling your financial plan. If you have planned your long term goals, this high inflation scenario is the time to review your plan. The biggest challenge would be ensure that you run a tighter ship rather than getting carried away by revenge spending. The investment surplus that it can create will be worth its weight in gold!

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