UBS: How to invest in a rising inflation environment

But that could be set to change this year. Inflation is now on the rise. Oil prices have doubled in the past 12 months, leading to sharp increases in consumer price indices (CPI) globally. Although oil only contributes around 5% to the US inflation basket, the magnitude of its price move has had a substantial impact, and higher oil prices also increase the costs of other CPI components, such as transportation and food. Meanwhile, the US jobless rate of 4.7% is close to cyclical lows, and wages are rising at their fastest pace in eight years. Even in the slower-growing Eurozone, unemployment has fallen to 9.6%, a post-crisis low. This is important since local labor costs generate about 70% of the relative increase in prices.

The stage is set for a cash-eroding revival in inflation. We think it is time to shift more assets out of cash and into assets that can perform better in times of higher inflation.

Equities with pricing power

Equities are better positioned than other assets to generate returns in periods of inflation accompanied by growth. CIO expects US revenues in the fourth quarter of last year to have expanded at their fastest pace in more than two years. Still, investors will need to be selective: some companies can respond to wage and input cost pressures by raising prices, while others will face compressed margins. CIO is overweight global and US equities in its global tactical asset allocation. Sector beneficiaries of rising inflation could include US and Eurozone energy stocks, US banks and real estate investment trusts (REITs), and Swiss dividend-paying stocks.

Inflation-linked bonds and senior loans

Rising inflation is generally not good news for fixed income returns – fixed coupons are eroded in real terms and increases in central bank rates adopted to curb inflation can also trim bond prices. The main exception to this rule is US Treasury Inflation Protected Securities (TIPS), whose par value climbs along with inflation. They stand to benefit as US inflation expectations rise, and can prove an attractive portfolio diversifier, with a low (+0.37) correlation to a balanced asset allocation.

Although more growth sensitive than inflation-linked bonds, US senior loans, in our view, can also deliver attractive returns if higher inflation is accompanied by rising rates, as their coupons reset higher when borrowing costs climb.

Palladium and platinum

Precious metals have historically benefited from falling real yields, and stand to benefit again today as central banks seem likely to raise rates more slowly than inflation rises. Palladium and platinum should be additionally supported by greater economic growth and industrial demand. The global auto industry accounts for 80% of total palladium and 40% of platinum demand.

CIO’s analysis also shows that hedge funds tend to generate superior returns to cash and stocks when higher inflation drives interest rate hikes. The HFRI Fund Weighted Composite Index rose 11.4% per annum on average during the last three US rate-hike cycles, compared to a 4.3% increase for US dollar cash and 7.6% for the S&P 500 Index (based on 1994–2006 data).

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