Lower returns beckon: here’s how to avoid them

As you may have noticed, markets are nervous. Having finally passed the 7000 mark in mid-April, the FTSE 100 has bounced around the 7000 level ever since, getting as high as 7130 before collapsing back to 6948. Today, as I write these words, it’s back below 7000 again.
 
In theory, markets should be more confident now, and not less confident. Despite the arrival of new Covid-19 variants, existing vaccines appear to be proving effective, and economies are gradually reopening.

Here in the UK, we can now go on holiday again, visit friends and relatives, and go to our local pubs and restaurants, where we can — gasp — eat and drink inside, rather than in a chilly marquee erected in a garden or car park.

A return to rising prices

Yet the resumption of all this economic activity has a nasty sting in the tail: inflation. Simply put, after being largely throttled back in very early 2020, expectations of surging business activity have led many observers to expect surging prices, too — starting with oil, plastics, metals, building materials, and commodities.
 
In the United States, those expectations are already being borne out.
 
Warren Buffett, for instance, has admitted to being caught out. Many people think of his Berkshire Hathaway (NYSE: BRK.B) investment vehicle as a fund, holding stakes in Coca-Cola, Procter & Gamble, and Kraft Heinz. So it does — but it also owns almost a hundred businesses outright, which gives Buffett excellent insight into United States economic activity long before it shows up in the official statistics.
 
And in early May, Buffett told Berkshire Hathaway investors at their annual meeting that the American economy was running “red hot”.
 
“We’re seeing very substantial inflation,” the Financial Times reported him as saying. “It’s very interesting. We’re raising prices. People are raising prices to us, and it’s being accepted.”

Squeezed returns

For investors, inflation isn’t good news.
 
The real inflation-adjusted returns from fixed income investments — bonds and gilts, in other words — fall, pushing down prices and pushing up yields.
 
Institutional investors respond by then increasing their purchases of fixed-income investments, and lowering the amount of equity investments they hold. The sell-off drives share prices down, as we’ve been seeing.

And it’s also the case that returns from equity investments can fall directly, as margins are squeezed through companies being unable to raise prices in line with the cost increases that they’re experiencing.

Household cleaning products manufacturer McBride, for instance, recently warned that its full year profits will be 15% lower than it expected as recently as March. The reason? “Rapid, significant, and sustained” price rises in its raw material costs.

What to do?

The good news is that not all stocks are impacted by inflation to the same extent. So it’s possible to sidestep some of inflation’s worst ravages in terms of the pain to your portfolio, and to your income stream.

Stocks with strong brands, for instance, have considerable pricing power. Better still are defensive stocks with strong brands — companies such as Unilever and Reckitt, for instance, or Diageo.

Property and infrastructure often holds up well, too — especially when rents and returns are linked to inflation as a reference point. Take a real-estate investment trust such as Primary Health Properties, for instance, which owns and rents out doctors’ surgeries. Inflation won’t do much damage there.

Likewise, utilities can be a safe home, as regulators take inflation into account when setting acceptable returns. Retailers with strong brands, too, can be relatively immune from inflation. Likewise pharmaceutical companies.
 
In short, there’s no dearth of options. Down the pub, the pundits might drone about inflation-linked savings products from NS&I — but with some judicious stock selection, we stock market investors can look to realise much better returns. Much, much better returns.