How to beat inflation: bonds and equities
Between 1970 and 1990, inflation reduced the value of every £1 to just 14p, according to calculations by Paul Killik, founder of stockbrokers Killik & Co.
For five years during that period, prices were rising by more than 15% a year and the average over the two decades was 10%. Between 2002 and 2012, by contrast, the average has been just a little over 3% and, apart from the odd blip, inflation this year has been falling again.
But even a little inflation is a dangerous thing: Tim Cockerill, head of collectives research at Rowan Dartington, points out that since 2005, the Consumer Prices Index (CPI) has increased by 22.5%.
Investors will have had to earn at least that return on their investments over the past five years to avoid eroding their capital but, with interest rates having been 0.5% since March 2009, getting that return from cash holdings has been nigh impossible, while the dismal stockmarket performance means that just 65 of the nearly 400 UK equity funds that have been around that long have delivered a return ahead of that inflation rate.
UK fixed interest funds have fared better, with 105 out of 130 beating inflation over the period.
Bad news for pensioners
Inflation is particularly bad news for pensioners and others whose income is fixed. Laith Khalaf, pension investment manager at Hargreaves Lansdown, says: "A pension will be drawn for 20 to 30 years, maybe more. Inflation is therefore always going to be a major threat to pensioners. Even at a modest level of 2.5%, inflation will halve the value of a fixed income over 28 years. At 5% it will halve it over 14 years."
Nor is there any guarantee that inflation will continue to fall. While the Monetary Policy Committee expects inflation to fall further this year, others are less convinced that the long-term trend will be downwards.
Simon Callow, manager of the CF Midas Balanced Growth Fund, is convinced that inflation will be a long-term issue for investors. "I am mystified that everyone seems so relaxed about inflation. You have to distinguish between what is happening in western economies [where growth and consumer demand have slowed sharply] and what is going on elsewhere.
Wages have increased sharply in China, so the products they manufacture are becoming increasingly expensive and that will be exported to the western world."
In addition, he says, agricultural commodities have been rising sharply - particularly corn and soybeans following the prolonged drought in the US. While commentators tend to write these offas one-off, weather related events, Callow points out that these "temporary" weather effects are happening every year, while the rising population is also increasing demand for foodstuff.
Quantitative easing (QE), under which the Bank of England has poured £375 billion into buying bonds in an effort to stimulate bank lending and the wider economy, and similar operations in the US and Europe could also push inflation higher in the medium term - indeed, the bank has admitted that inflation is already higher than it would otherwise have been because of QE.
"The huge increase in the money supply will increase inflation at some stage," says Peter Day, a partner with Killik & Co.
So how can investors protect themselves against inflation?
GILTS AND BONDS
While these have beaten inflation in recent years, there is a question of whether now is a good time to buy bonds. Many commentators believe we are coming to the end of a prolonged bull market in bonds and that the risks are increasing.
QE, coupled with investors' quest for safer investments, has pushed the price of gilts and blue-chip corporate bonds sharply higher. However, if inflation returns, putting pressure on interest rates, or investors' attitudes change, gilt and top-rated bond prices could fall, leading to the risk of a capital loss.
Brian Dennehy, managing director of financial advisers Dennehy Weller & Co, comments: "Corporate bonds, as fixed income assets, inherently lack the ability to grow income. [They] feel like a safe haven but it is a safe haven like driving a Volvo along the top of Beachy Head - you do it carefully.
"We're towards the end of a 30-year bull market in bonds (the Beachy Head cliff edge), so there are clear risks, particularly if you think you can sit in bond funds as a long-term holding - there will be a point when you need to be agile; it might not be next month, or even next year, but you need to be ready."
Jason Hollands, managing director of business development and communications at Bestinvest, says high-yield corporate bonds can offer a better hedge against inflation as the income is greater – some offer yields of 7% or more. However, the high yield is to compensate for the greater default risk of a high-yield bond, so it may be better to buy a diversified, "strategic" bond fund.
Equities are one of the traditional ways of hedging against inflation. Over the long term, share prices will rise while rising dividends also bring increasing income. Some companies, such as utilities, offer a specific inflation hedge as regulation allows them to increase profits in line with inflation. Others, such as pharmaceutical and tobacco companies, whose products are generally in demand, offer similar prospects.
The current yield on the FTSE 100 index is 3.4%, ahead of the inflation rate. As Day points out, investing in equities is higher risk but he adds: "A strategy of investing in high quality defensive equities in companies that can increase prices in line with inflation and so can increase their dividends too should see share price rises and be an excellent long-term investment."
This article was written for our sister magazine Money Observer
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
Monetary Policy Committee
A committee designated by the Bank of England to regulate interest rates for the UK. The MPC attempts to keep the economy stable, and maintain the inflation target set by the government and aims to set rates with a view to keeping inflation at a certain level, and avoiding deflation. The MPC meets on the first Thursday of each month and discusses a variety of economics issues and constitutes nine members: the governor, the two deputy governors, the Bank’s chief economist, the executive director for markets and four external members appointed directly by the Chancellor.
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
The familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.
Lower interest rates encourage people to spend, not save. But when interest rates can go no lower and there is a sharp drop in consumer and business spending, a central bank’s only option to stimulate demand is to pump money into the economy directly. This is quantitative easing. The Bank of England purchases assets (usually government bonds, or gilts) from private sector businesses such as insurance companies, banks and pension funds financed by new money the Bank creates electronically (it doesn’t physically print the banknotes). The sellers use the money to switch into other assets, such as shares or corporate bonds or else use it to lend to consumers and businesses, which pushes up demand and stimulates the economy.
A market-weighted index of the 100 biggest companies by market capitalisation listed on the London Stock Exchange. It is often referred to as “The Footsie”. The index began on 3 January 1984 with a base level of 1000; the highest value reached to date is 6950.6, on 30 December 1999. The index is “weighted” by how the movements of each of the 100 constituents affect the index, so larger companies make more of a difference to the index than smaller ones. To ensure it is a true and accurate representation of the most highly capitalised companies in the UK, just like football’s Premier League, every three months the FTSE 100 “relegates” the bottom three companies in the 100 whose market capitalisation has fallen and “promotes” to the index the three companies whose market capitalisation has grown sufficiently to warrant inclusion. Around 80% of the companies listed on the London Stock Exchange are included in the FTSE 100.
A term applied to raw materials (gold, oil) and foodstuffs (wheat, pork bellies) traded on exchanges throughout the world. Since no one really wants to transport all those heavy materials, what is actually traded are commodities futures contracts or options. These are agreements to buy or sell at an agreed price on a specific date. Because commodity prices are volatile, investing in futures is certainly not for the casual investor.
The Consumer Price Index is the official measure of inflation adopted by the government to set its target. When commentators refer to changes in inflation, they’re actually referring to the CPI. In the June 2010 Budget, Chancellor announced the government’s intention to also use the CPI for the price indexation of benefits, tax credits and public sector pensions from April 2011. (See also Retail Prices Index).
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
A bull market describes a market where the prevailing trend is upward moving or “bullish”. This is a prolonged period in which investment prices rise faster than their historical average. Bull markets are characterised by optimism, investor confidence and expectations that strong results will continue. Bull markets can happen as a result of an economic recovery, an economic boom, or investor irrationality. It is the opposite of a bear market.