As soaring inflation continues to hit the headlines, it’s a worrying time for charities who are facing rising costs and declining real income, and in many cases, resourcing challenges, upward pressure on wages, and increased demand for their services. Concerns about inflation have also been a key driver of market volatility this year, leaving many wondering how it will impact their investment returns.
Much has changed since our article 'When inflation and charities collide', so here we discuss how inflation can impact equities, and what it could mean for charity investors.
How does inflation impact equities?
Broadly speaking, there are two ways inflation can impact equities. First, while company revenues could increase thanks to their higher selling prices, the result on profits could be negative if input costs rise faster. Second, there’s interest rate risk to consider. If central banks hike rates too aggressively, and push some economies into recession, equity valuations could come under yet more pressure.
However, inflation often impacts companies differently which is why it’s not automatically a bad thing for equity investors. Those firms with genuine pricing power, for example, which are able to price products and services at a premium without affecting demand, should be more profitable that those which struggle to pass on costs to customers. Businesses use a range of tools to achieve pricing power, but very often rely on ‘intangible assets’ to give them a durable competitive edge, such as a world-renowned brand name, unique distribution networks, or leading intellectual property that’s difficult to replicate.
Having an asset-light business model can be especially valuable during inflationary periods. This allows companies to increase sales sustainably without having to invest significant amounts in things like plant, machinery, and inventory, when the costs of these items may be rising. These businesses may not have to raise as much fresh capital (or use profits) to deal with inflation as asset-heavy firms, so their return on capital will likely be better protected from inflation.
Indeed, both attributes can be attractive for long-term investors whether inflation takes hold or not. Investing in intangible assets to sustain pricing power can help protect against competition, while less capital-intensive businesses may be able to free up cash to pursue future growth, or return cash to shareholders.
Building a well-diversified portfolio of high-quality companies should help weather any short-term inflation-related turbulence and deliver long-term returns.
A long-term game
While past performance is never a guarantee of future performance, some historical context here is interesting. Over the long term, equities have historically outperformed inflation by a clear margin, but it’s not all been plain sailing. For example, the FTSE All Share index has outperformed UK RPI on a year-on-year basis 62% of the time since 1963, with an average outperformance of 3.6% (Source: Bloomberg, Barclays Private Bank, December 2021), but within that period we’ve seen some very high inflation prints – and sharp market moves.
Equities vs inflation
Year-on-year returns for the FTSE All Share index and annual inflation based on the UK Retail Price Index, 1963-2021
Source: Bloomberg, Barclays Private Bank, December 2021
Meanwhile, the Barclays Equity Gilt Study 2021, which looks at data since 1899, shows that over two consecutive years, UK equities have outperformed cash and UK government bonds 69% of the time. Over a ten-year period, this rises to 91% (Source: Barclays Equity Gilt Study 2021).
What’s next for charity investors?
Financial markets are likely to remain volatile for the next few months, and we now expect lower growth and higher inflation globally for the remainder of the year.
That said, there is reason for hope. Broadly speaking, inflation should peak soon, before gradually moderating in the coming months. And although growth is slowing, and could turn negative temporarily in parts of the world, it should normalise towards trend growth this year and next on a global basis.
Many charities’ investment portfolios were established with a long-term horizon to weather challenging conditions such as these, and while it may feel tempting, selling investments in down markets can be costly. There are other ways to ease short-term liquidity pressures, such as lending against investments, provided you have robust longer-term plans in place (and subject to eligibility criteria). In this environment, it’s especially important to ensure your portfolio is well-diversified, and to maximise returns on cash reserves as interest rates rise.
Olivia Lewis is private banker – charities & not-for-profits at Barclays Private Bank
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