If you've been keeping up with recent economic data, you may be forgiven for thinking that investors have little to worry about inflation. After all, the Bank of England has undershot its 2% inflation target for more than two-and-a-half years. And even after the Brexit vote, the CPI inflation rate has remained stubbornly low - just 0.6% for the year to August.
However the economic consensus indicates that inflation should pick up more sharply in the coming months. Consumers, for the most part, haven't felt the impact of the falling value of the pound, because most major retailers have hedged their foreign currency needs, while many others have absorbed higher import prices. This can't last forever though, and businesses that have already had to implement the national living wage earlier this year may struggle to absorb further cost pressures.
Below are three stocks that should protect your portfolio against rising inflation.
RPI protected dividends
Water utilities offer good protection against inflation because wholesale revenues are indexed to inflation each year. As regulated monopolies, regulators set prices to allow water companies to earn a specified return over the costs of running services and on the capital that companies have to invest in their infrastructure. If these costs rise due to inflation, water companies are allowed to pass on higher water charges to consumers, enabling investors to earn a steady return.
In this sector, United Utilities(LSE: UU) stands out because of its relatively cheaper valuation and higher yield. The stock currently yields 3.9%, with the company maintaining a policy of targeting annual dividend growth of at least RPI inflation through to 2020.
On the downside, higher inflation could prompt the Bank of England to raise interest rates. As water companies tend to have relatively high levels of leverage, higher borrowing costs could have a significant impact, lowering profits. Right now though, that prospect seems unlikely given the Bank of England's loose monetary policy stance.
Property is a natural hedge against inflation. That's because, as property is a 'real' asset, investors have the ability to renegotiate rents during periods of unexpected increases in inflation.
Following Brexit, UK commercial property values have taken a hit, but that doesn't mean investors should avoid the sector entirely. Target Healthcare REIT's (LSE: THRL) focus on healthcare properties adds defensive characteristics to an otherwise cyclical investment. The REIT benefits from secure long-term rental leases, with a weighted-average unexpired lease term of 29.2 years. In addition, a majority of its leases benefit from upwards-only RPI-linked annual rental increases.
The stock currently yields 5.6%, and trades at a 10% premium to NAV.
Strong pricing power
Although Diageo's(LSE: DGE) revenues don't directly rise with inflation like the other two stocks on the list, the company's wide economic moat and pricing power help to protect margins against inflationary pressures. Diageo's 27.1% organic operating margin reflects the value of its intangible assets, which lies at the heart of the company's share price performance over the past decade.
Moreover, thanks to its massive collection of Scotch whisky brands, the drinks giant's large UK cost base means it's set to benefit from the cheaper pound. Analysts have been busy upgrading their estimates for earnings in 2016 and 2017 over recent weeks and now value the company at a forward P/E of 21.5 for this year and 19.6 for the next one.
Jack Tang has no position in any shares mentioned. The Motley Fool UK has recommended Diageo. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.