To beat inflation, you may have to take risks

17th October 2013

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In case anyone’s missed the headlines, energy bills are rising. There is considerable debate as to why that might be, and what can be done to stop it, but it should remind investors that inflation is a too-often neglected part of investment selection. There is a still a widely held view that cash is a decent way to preserve long-term wealth. It isn’t, but what else can investors do asks Cherry Reynard?

To recap, the latest inflation figures showed CPI running at 2.7%, the 46th month it has sat above the Bank of England’s 2% target. This time it was driven higher by air fares, which rebounded after heavy discounting this time last year, but as the winter months hit, rising energy bills are likely to drive it higher once again. A number of the energy companies have already announced price rises significantly ahead of inflation. This is not a new trend. Inflation has consistently over-shot both the Bank of England’s target and its expectations. Wage growth has not kept pace, but in a relatively tight labour market this is unlikely to change. As this Independent article points out, British workers have suffered one of the biggest falls in real wages among European countries over the past three years as the Independent reported earlier.

So people need their long-term savings to beat inflation or face problems later on, as those savings will have been eroded and prove insufficient to meet their cost of living.

At this level inflation has a consistently corrosive effect on portfolio returns. It has averaged 3.2% over 10 years. Pre-credit crisis that level of income may have been available in a bank account, but only a handful of savings accounts pay that now. It is clear that people need to look elsewhere.

Here, there is the theory and the reality. The theory is that for inflation protection, the risk averse should look to inflation-linked bonds, while those with more risk appetite should look to equities and commercial property. At times of higher inflation, equities tend to do well because companies can put up their prices, and therefore pay their investors higher dividends or see it reflected in share price growth. Similarly with commercial property, landlords can put up rents at times of economic expansion. Again, this is returned to

investors as higher income, or higher capital growth.

The trouble is by the time that people realise they have an inflation problem it can often be too late. Some inflation linked bonds, for example, became so popular when investors believed that quantitative easing was going to create rampant inflation, that they ended up paying a negative yield. In other words, investors were locking in a return guaranteed to be lower than inflation over the maturity of the bond. There were complicated reasons behind this – see this explanation from the Bond Vigilantes at M&G – Bondvigilantes.

but it meant that inflation protection came at an extremely high price for investors.

That said, bonds have been through a major correction and this Motley Fool article argues that inflation-linked bonds now offer good value.

But what about equity and property? Have they offered protection against inflation? The answer is that sometimes they have an sometimes they haven’t. According to the handy Bank of England inflation calculator, to protect the buying power of £1,000 over the past five years, it would now need to be worth £1,175, in other words, a return of 17.5%.

On this crude metric, pretty much whichever equity sector an investor had chosen would have protected against inflation, from the worst – Japan with an average return of 72% – to the best – North American Smaller Companies, with an average return of 152% according to Trustnet. There again, these figures run from a time – October 2008 – when the world was collapsing. Lehman Brothers had just gone bankrupt and markets had taken a nose-dive. Investors fear at the time was of permanent deflation rather than rampant inflation.

In times when there were valid fears of inflation – such as the 1999/2000 technology bubble – equities were already riding high. Investors who invested then may just be making their money back now and have certainly received no inflation protection over that period.

Commercial property funds have just beaten inflation, with the average fund rising 34% over 5 years, but again the picture is slightly deceiving. Investors who bought before the crash when markets and economies were booming – and therefore inflation expectations would have been at their highest – lost as much as 30% before commercial property funds resumed their steady rise.

The peril for investors is that by the time inflation worries emerge with any vigour, ‘inflation-protected’ assets are already expensive, and therefore – perversely offer no inflation protection. Investors need to be alert to the price they are paying when they are buying inflation-protection or they may find it doesn’t help them at all.

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