Holly Cook: Hello and welcome to Morningstar. Today I'm joined by Peter Warburton. He is a Director at Economic Perspectives, and we're going to be looking at what investors can do to protect their investments from inflation.
Peter, thanks for joining me.
Dr. Peter Warburton: Pleasure.
Cook: So, you recently gave a presentation in which you talked about how investment returns can be split between sort of real returns and that inflation protection. Can you explain what you mean by that split?
Dr. Warburton: Yes. I think in a growing economy – and obviously for the last 40, 50 years that's happily been the typical state of the global economies – if it’s been growing then in a sense your investment strategies are to capture that growth, and typically in equities for the main, but obviously some pretty good real returns have been obtained in bonds as well.
So, if you like, the harvest of global growth has been obtained in both equities and bonds. But really that isn't always the case and there are times actually where protecting yourself against high and volatile inflation is very important, and I want to argue that actually we're approaching one of those times again now.
Cook: So, let's sort of take the two parts in turn. First off, the yield element triggered by the global economic growth; what's your current outlook for that area of return?
Dr. Warburton: I think it is to slow. I mean, there are a number of arguments, and I think everybody would probably put a different weight on each one. But there is a demographic argument that in the advanced countries the population of working ages is growing slowly or declining. There is an argument about energy becoming more expensive and we feel like putting more effort into getting energy and less effort into everything else. But that's gone into reverse slightly just very recently. There are arguments about the debt that we've built up, particularly in the 1990s and 2000s and whether that was pulling growth forward from the future and now we're in that future which is impoverished. So, there were kinds of arguments to be made and I think you know it’s quite credible to say that our growth outlook is weaker than it was.
Cook: So, for the inflation side of things, obviously, for the average man on the street he feels like prices inflating is bad news because it hampers your purchasing power. But is there a sort of positive side to inflation as well?
Dr. Warburton: There are certainly beneficiaries of inflation as well as losers. But I think the key thing is that we have lived through an extraordinary period where certainly government bond yields have fallen very low and many people believe that this is associated with a deflationary future and I think that's a very dangerous assumption or assertion to make.
I would say that we have lots of very sort of distorted bond markets at the moments obviously through quantitative easing, forward guidance and the repression of interest rates across the curve and actually we are extraordinarily vulnerable to a reversal of inflationary trends. What rising inflation would mean almost certainly is that it would not only have a negative impact on bond returns but it would probably de-rate equities as well.
So, I think this is the time to be thinking that actually inflation protection is actually quite cheap, in fact, very cheap in markets at the moment. So, this is the time to be looking further ahead and considering how different the world might be.
Cook: So, obviously, no one has that crystal ball. It's very difficult to guess what's going to be coming ahead. But what are some of the key tools available to investors to build in that inflation protection into a portfolio?
Dr. Warburton: Yes, I don't think you can inflation-proof a portfolio but you can protect. Obviously, there are available in most countries inflation-protected bonds, so TIPS in America and index-linked gilts in the UK and so on. What's been quite interesting is that they've actually performed well even as inflation has fallen. So, the real yield aspect has actually delivered a return even though the inflation hasn't.
But no, I think, were we to resume inflation moving up towards 3%, 4%, 5% or beyond, then you very definitely want to have inflation-protected bonds. Obviously, some countries you don't get proper compensation. So, if you go into the emerging markets phase, then you definitely don't get full compensation from your bonds.
Other things, I think obviously you can if you're sophisticated buy inflation derivatives. But I would say those are trading strategies rather than long-term investments.
I think most of your inflation protection really is in equities where you can get companies that own real assets, physical assets and also have franchises in products and services which are enduring and therefore they are enduring and therefore they are inflation protected to some degree.
Outside that I would say that real estate, particularly commercial real estate is a very interesting part of inflation protection provided clearly that those investments are not using leverage in the shorter end of the markets. Obviously, if you were to get a sharp upward move in short-term interest rates then that would more than offset your inflation protection in the asset.
Cook: And of course, for those people who have a mortgage as well, there would be a double whammy, as it were then.
Dr. Warburton: Yes, that's right.
Cook: Peter, thanks very much for explaining those options for us, some very useful information.
Dr. Warburton: You're welcome. Thank you.
Cook: For Morningstar, I'm Holly Cook. Thanks for watching.
