Turn back the clock for some answers
Believe it or not, but it was as recently as May when headlines were suggesting that stagflation could once again haunt our policy makers.
The trigger for this was the official measure of inflation reaching 3% — up from 2.5% the month before.
By July that measure had soared to 3.8% and the latest figures show that it now stands at 4.4% — despite an official, government target of 2%.
There are other statistics painting a similarly gloomy picture. Factory gate prices are now rising at 10% p.a. — the highest since 1986. Input prices have reached a 30% year on year increase and exceeding the peak rates of both oil shocks in the 1970s.
Any inflation shock is unwelcome. But, coming on top of a credit crunch that has triggered a sharp drop in house prices and commercial property, has added additional pain.
Normally this would have been accompanied by aggressive interest rate cuts, but the Monetary Policy Committee has been caught between a rock and a hard place and seems frozen, for the moment, in inaction.
So we have rising costs and slowing growth, which is all too reminiscent of the 1970s.
And this is not just a UK phenomenon. A similar problem confronts central bankers in all of the larger, developed economies — from the US to Europe and Japan — as the demand for commodities from emerging markets such as India and China drive up those prices.
So is there anything the investor can do within their portfolio to protect it from sudden falls? History shows that certain asset classes perform better in different situations. This applies irrespective of where we are in an inflationary cycle.
So, assuming an investor can identify where they are in the cycle, they should be able to pick assets accordingly.
Fine as far as it goes, perhaps. But the only way to find out which asset works best in whichever situation is to look back historically.
The inflation cycle goes approximately thus:
l The first phase is reflation, which is characterised by weak growth with falling inflation. In this stage government bonds offer the best returns.
l During the next, recovery phase, interest rates cuts work their magic and equities are favourite. Growth stocks and smaller companies among the best options.
l Then, at some point, things change and either a bottleneck occurs or, as we have seen, a sudden financial crisis precipitates a move into stagflation. Growth slows and inflation lingers like a bad hangover. Periods like this have tended to last about 16 months.
Cash can outperform but, with inflation at current levels, this is unlikely in the current, recessionary environment.
Commodities can do well but you need to do your research well to see which is the best way to invest.
Looking at pure equities, the type of stocks you might consider are non-cyclical such as gas, oil, pharmaceuticals and utilities.
If you want to stay with the unit trust vehicle ,then you need to find funds that reflect these shares.
You can use alternative asset classes such as Exchange Traded Funds, Futures and Private Finance Funds, all of which are usually unaffected in this part of the cycle. Either way, investors need to realise that we are in a period, due to last at least 15 months, when you are likely to lose more than you gain if your portfolio is not focused.
Nicholas Watts is an independent financial adviser with Positive Solutions Financial Services which is regulated by the Financial Services Authority.|To contact him, use the website www.realwealthmanagers.co.uk