Last month's fall in inflation to 0.9% is likely to be a red herring. Few investors or policymakers expect inflation to remain at such a low level while sterling is weak. In fact, The Bank of England forecasts that inflation could reach almost 3% in 2018. Therefore, it could prove crucial for investors to focus on earning a return above and beyond 3% in order to generate a real-terms return (i.e. after inflation) on their investments.
One way of doing so is to buy shares. The FTSE 100 currently yields around 3.7%, so even if inflation reaches 3% then investors will still receive an income return that provides a real-terms return. However, it's not all that difficult to generate a yield in excess of 4% or even 5% through picking stocks that have higher yields. Sectors that offer 4% yields range from defensive stocks such as tobacco, healthcare and utilities, to cyclicals such as travel/leisure companies, retailers and consumer goods firms.
Furthermore, many FTSE 350 shares are forecast to increase their dividends at a faster pace than inflation. This means that their income return should allow those investors who live off dividends to maintain and even improve their standard of living, even if inflation rises to 3%. And even if earnings growth disappoints due to the challenges faced from Brexit and a Trump presidency, many companies in the FTSE 350 have modest payout ratios. This means that they can continue to increase dividends at a faster pace than earnings growth, thereby providing a real-terms rise in their shareholders' income.
Shares also offer protection against inflation because they operate in the real economy. In other words, inflation reflects the changes in price levels in the economy. Companies operate in that same economy and so will reflect higher inflation in their prices and profitability.
Clearly, this will not be the case for all companies. Retailers, for example, may struggle to pass on higher costs to consumers since there is a huge amount of competition. However, where brand loyalty is high such as in tobacco or consumer goods markets, it may be possible for those companies to pass on the full amount of higher costs. As such, it may be prudent for investors who are worried about inflation to focus on stocks that enjoy relatively inelastic demand for their products.
Investors have become rather used to low inflation and the risk of deflation. That has been the main theme for the last handful of years. As always though, things change and the next few years look set to represent a reversal in terms of inflation moving higher and a real-terms return becoming more relevant to investors. While investing in shares carries risk, they offer an appealing hedge against higher inflation. Therefore, now could be a good time for long-term investors to add more shares to their portfolios.