How to beat inflation: property and commodities
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?
Property has traditionally been seen as a hedge against inflation although, in recent years, this has not been obvious as the sharp drop in loan flinance available and the economic slowdown have hit capital values.
Dennehy points out that, since 2000, the pay-out on the Aviva Property Trust has fallen by 25%, with similar drops in comparable funds, while payouts from equity income funds such as Schroder Income have doubled.
Cockerill questions whether property can regain its inflation-hedging status. "I can’t help feeling we are now in an economic period in which the 'laws' governing inflation and economics have perhaps shifted, if only temporarily.
"The excess of money in the economy has, over the past 10 years, seen some asset prices inflate dramatically, such as property, and the reduction in interest rates has helped sustain much of this rise. The difflicult thing is to know whether buying property now, prices having fallen, will in the long term prove to be an inflation hedge."
Rising commodity prices are one of the factors fuelling inflation so, unsurprisingly, they are seen as a useful inflation hedge. The traditional commodity for this purpose is gold, but the evidence is not compelling and the recent surge in its price means there is a high risk of correction.
"Over the very long term, data suggests a high correlation between gold prices and inflation," says Hollands. "However, we feel a big caveat needs to be placed when looking at the long-term data for gold, which is that over the last couple of years they have become increasingly correlated to equities.
"We think this is due to the proliferation of exchange traded funds that have enabled a wide range of investors, including hedge funds, to trade the prices of commodities for a wide range of underlying strategies.
"Currently the prices of platinum and gold are being impacted by strikes across South Africa, so if you pile into gold now you are likely to see some short- to medium-term volatility as the situation unfolds."
Commodity prices are unpredictable, volatile and high risk. For those who are prepared to accept that, there is a wide range of commodity ETFs as well as funds to choose from.
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.
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 sophisticated absolute return fund that seeks to make money for its investors regardless of how global markets are performing. To that end, they invest in shares, bonds, currencies and commodities using a raft of investment techniques such as gearing, short selling, derivatives, futures, options and interest rate swaps. Most are based “offshore” and are not regulated by the financial authorities. Although ordinary investors can gain exposure to hedge funds through certain types of investment funds, direct investment is for the wealthy as most funds require potential investors to have liquid assets greater than £150,000m.
This is more usually a feature of car insurance but it can also crop up in contents, mobile phone and pet insurance policies. An excess is the amount of money you have to pay before the insurance company starts paying out. The excess makes up the first part of a claim, so if your excess is £100 and your claim is for £500, you would pay the first £100 and the insurer the remaining £400. Many online insures let you set your own excess, but the lower the excess, the more expensive the premium will be.
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 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.