Eight investment ideas to benefit from rising inflation

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While the actual increase is hotly debated, it is widely accepted that inflation will soar in 2017. Most think the Monetary Policy Committee's 2 per cent target will be smashed very soon, driven higher by a plunge in the pound since the Brexit vote.

A resultant surge in the cost of imported goods is already being passed onto the consumer, putting pressure on household budgets. High street bellwether Next warned this month it will hike the price of clothes by 5 per cent.

Earlier this month, the Office for National Statistics (ONS) said higher air fares and food costs had driven inflation to a 30-month high at 1.6 per cent in December.

'Higher inflation is on the way, which will erode consumer incomes, while the impact of uncertainty since the referendum may cause investment spending to slow this year,' warned CBI chief economist Rain Newton-Smith on Monday.

INFLATION TRADES

'The New Year sees the arrival of headwinds that may challenge the current consumer-friendly economic conditions,' adds Deloitte economist Ian Stewart.

On Thursday, the Bank of England publishes its latest quarterly inflation report. In November, it increased estimates for consumer price inflation (CPI) to 2.7 per cent from 2 per cent previously, up from 1.3 per cent expected at the end of 2016.

There's an obvious impact on equity markets if rising inflation increases costs for companies, leading to cuts elsewhere in the business in order to maintain profits. On the flipside, corporate earnings should grow in line with inflation.

Given the inevitable uptick in inflation globally, analysts at UBS have devised eight investment ideas they believe will perform well in the coming months, as inflation continues to rise.

'In general, equities tend to outperform bonds in an inflationary environment,' explains the broker.

'Bonds tend to perform poorly in periods of rising inflation as central banks adjust interest rates higher and yield levels rise. Equities often benefit from company sales growth increasing with inflation, despite the negative impact from rising interest rates.'

US ENERGY STOCKS

With that in mind, UBS analysts Jeremy Zirin and Nicole Decker like the US energy sector.

A Saudi-brokered deal to cut production offers upside risk to UBS's base case oil price forecast. 'Our expectation is that WTI oil prices will rise over coming months, lending a positive outlook for S&P 500 energy stocks,' it says.

Earnings should also bounce back sharply this year from depressed levels, and valuations remain the long-run average.

'[UBS] recommends that energy investors focus on financially strong, efficient operators with top-quality assets. [It] prefers exploration and production, and oil services companies, whose earnings are most sensitive to changes in oil prices.'

UBS analyst Bradley Ball is a fan of US banks: 'Banks are a clear winner from reflation as stronger economic activity supports increased commercial and consumer investment spending along with loan demand (increasing client engagement, trading and capital markets activities); higher interest rates have the potential to boost bank net interest margins; and improved asset quality (stabilising/improving loan loss rates).'

If Trump comes good on his promise to lighten regulation, banks can redeploy excess capital into growth areas including loans, investments and mergers and acquisitions.

EUROPEAN OIL PLAYS

Across the Channel, higher oil prices are tipped to drive not only eurozone inflation but also sector profits. High operating leverage should generate a strong recovery in free cash flows for European oil plays as investment stabilises.

'The sector's above-average dividend yield of close to 5 per cent looks attractive in an environment where dividends are likely to make up a significant part of total equity returns, given the limited potential for PE expansion due to rising inflation,' says UBS analyst Bert Jansen.

Turn south and head for Switzerland urges UBS where, despite low inflation, costs should begin to rise, increasing the attractiveness of companies with the ability to raise dividends as earnings increase.

'Rather than simply buying the highest-yielding stocks, investors should select 'high-quality dividends' that exhibit high dividend sustainability coupled with decent growth.'

Back over the pond, and Jonathan Woloshin likes US real estate investment trusts, which now trade only in line with the S&P 500. Over the past six years, they've typically traded at an 11 per cent premium.

'Historically, commercial real estate (CRE) has provided a good inflation hedge when rising prices have resulted from improving economic conditions,' writes Woloshin.

'An accelerating US economy should lead to greater demand for CRE and provide landlords with more pricing power, something that could help offset the risk of rising interest rates.'

PRECIOUS METALS

Analyst Rochus Baumgartner likes higher-risk corporate hybrid bonds - a mixture of debt and equity. In euros, BBB-rated short call securities still offer a yield of 1–2 per cent, he points out, compared with near-zero for a similarly-rated senior bond of similar duration and effective maturity.

Platinum, palladium and gold piques the interest of UBS. It forecasts inflation growth will outstrip interest rates rises, driving real interest rates further into negative territory. 'This environment favours yield-free real assets like precious metals,' it says.

'We favour industrially oriented precious metals, like palladium and platinum,' adds the broker, but it acknowledges that gold offers some insurance in the event of 'policy mistakes', a spike in inflation, or weaker-than-expected growth.

Finally, UBS thinks a diversified hedge fund portfolio is ideal in the circumstances. It says research shows hedgies are fairly resilient both to rising inflation and interest rates. In fact, they tend to rise when inflation does.

'If inflation does rise gradually, especially from a low base, then equities tend to benefit,' says UBS. 'And hedge funds have a positive, albeit small, beta to equities and should gain from such a move.

'Meanwhile, if inflation accelerates well ahead of market expectations, equity market volatility could rise, and extend the range of opportunities available to hedge funds further.'

interactive-investor-logo-small-sizeThis article was originally published on our sister website Interactive Investor.


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