The latest figures show UK inflation as measured by the CPI at 4.4% while interest rates languish at 0.5%. So how can you avoid the erosion of cash deposits and maintain the real purchasing power of invested capital? Before attempting to devise an investment strategy to mitigate inflation, it's critical to take a step back to understand its underlying causes. Bank of England governor, Mervyn King, attributes the rise in the UK rate to three factors over the past four years – a 'perfect storm' of inflation shocks. There has been the rise in import prices – 20% over the past four years – compounded by a weak pound. Similarly, energy costs have soared while VAT has pushed the CPI upwards.
Divided opinion
The Monetary Policy Committee has been divided into two camps. The 'hawks' have claimed that the UK economy has lost capacity permanently and that the output gap – the difference between actual and potential GDP – is much narrower than previously assumed. They say that if this is the case, as the economy recovers, the rise in headline inflation will translate into rising inflationary expectations (although as economic growth has continued to disappoint, the number calling for a rise in rates has fallen), hence their belief in the need for an early increase in interest rates.
The 'doves', led by Mervyn King, have consistently argued that the current spike in inflation is temporary and that the UK economy is too fragile to absorb an increase in interest rates with the economy still recovering from deep recession and consumer debt levels so high. The labour market is in no position to kickstart a wage cost spiral. Consequently, real disposable incomes (i.e. after the effects of inflation) are likely to remain under pressure. Also, with a very fragile housing market, now is not the time to impose higher mortgage rates, they say. A tight fiscal policy needs to be counterbalanced by a loose monetary policy. So, according to the doves, the rise in CPI is temporary and is forecast to subside next year.
The future direction of inflation will depend upon many factors including exchange rates and indirect taxation, but it would seem sensible to position portfolios for an environment in which nominal GDP growth (i.e. real GDP growth plus inflation) is disappointingly low, interest rates close to zero and inflation of 2%-3% per annum.
Investors need to try to secure positive 'real' returns (i.e. after inflation) while ensuring they have well diversified portfolios invested across a broad spectrum of asset classes, such as those outlined next.
Diversity is key
Equities – inflation could see equities benefit from both rising prices and unit growth, but we would concentrate upon well-capitalised, international companies with scope to increase their dividends over the coming years. Dividends are likely to become an increasingly important part of total return going forward.
Inflation-linked bonds – even though real yields (i.e. the return to maturity after inflation) have fallen, there is scope for them to fall further. After all, in the 1950s to 1970s negative real interest rates were the norm. Medium-dated UK indexlinked government bonds (index-linked gilts) are only factoring in around 1.5% retail price index annual accrual rates going forward, which may prove too low. (Source Bloomberg)
Gold and silver – traditional inflation hedges. The 1980 peak in gold in 'real' terms was US$2,251 which compares with a current price of around US$1,800 (Source Reuters).
Commercial real estate – over the long run, commercial real estate has been a reasonable inflation hedge. However, because rents are renewed at fixed periods, commercial property can incur time-lag penalties while investors also carry the risk of periods of vacancy and illiquidity.
Risk warning
Investment does involve risk. The value of investments and the income from them can go down as well as up. The investor may not receive back in total the original amount invested. Past performance is not a guide to future performance. Rates of tax are those prevailing at the time and are subject to change without notice. Clients should always seek appropriate advice from their financial adviser before committing funds for investment. When investments are made in overseas securities, movements in exchange rates may have an effect on the value of that investment. The effect may be favourable or unfavourable.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
