The impact of inflation on UK investments

When important institutions such as the Bank of England begin to look silly we may derive some idle amusement from their embarrassment.

So it is when Consumer Price Inflation rises to double or more the target rate of 2%. But our laughter can only be hollow because we know some serious mistakes are being made.

As investors we must puzzle over a paradox. On the one hand, the Bank feels that the economic recovery is so fragile it dare not raise interest rates from the emergency levels set more than two years ago.

On the other hand, the stockmarket appears to be relatively strong; British companies have been delivering decent profits and are full of cash.

Two years ago the Bank's Monetary Policy Committee (MPC) was obsessed with deflation: this prospect terrifies economists because the expectation of lower prices encourages consumers to wait for better buying opportunities and hoard their cash.

The trouble is, the Bank is targeting growth and employment, not inflation. But the men of Threadneedle Street do not dare admit this for fear that government bond yields would rocket and the Treasury would find it impossible to finance its huge budget deficit at any affordable price.

So what's the best approach?

My advice at the start of the year was to avoid fixed income bonds and stick with equities. That remains the least risky approach because bonds have become, if anything, even more dangerous in recent months.

But it is no good dreaming that the equity market will withstand for very long a really sharp rise in bond yields, though there is likely to be a time lag.

We are in all this economic trouble because the Western world has lost control of the global economy, which has increasingly come under the influence of the so-called emerging countries.

Not only have British jobs been lost as cheap imports have flooded in, but now the still-booming Third World is pushing up commodity prices so that the Bank of England is involved in a battle against inflation for which it no longer has any effective weapons that it feels able to use.

A few years ago we were importing deflation; now inflation is surging in.

So is there a way out?

There could be a way out of this mess. Over the past year or so, Germany has shown that it is possible for Western economies to fight back. It has done so by exporting goods to China and other fast-expanding Asian countries.

The UK could make progress in the same way: orders for manufacturers have been strong and the cutbacks in the public sector will allow plenty of room for the private sector to expand.

Such a 'recovery' will, though, depend on a sharp fall in living standards. We have already been hearing bad news about the retail sector: a shift from imports to exports has to come and it will not be a pleasant experience for most of us. This could be a recovery that feels more like a slump.

Remember that the coalition government, unlike the Labour opposition, cannot afford to defer the pain. It is hoping to stay in office for a full five-year term, and it will gamble that a bad first three years will be followed by two better ones, giving good electoral prospects in 2015 for the Conservative Party.

But it is arguable, of course, whether the flimsy coalition will last for anything like five years.

So far, one of the government's few successful policies has been the stabilisation of the housing market, by forcing unfortunate savers to cross-subsidise borrowers. House prices have been steady for some months, though activity levels have been very low.

Now the risk is that rapid inflation may force the MPC to raise Bank base rate sharply and squeeze homebuyers.

Elsewhere, the government is taking an enormous gamble that the private sector will fill the gap left by the shrinkage of the public sector. We shall find out over the course of the coming summer whether such a strategy will possibly work. An oil shock is looming and would cause severe problems.

An all-too-likely outcome is that the Bank will keep the base rate very low and accept high inflation. By the autumn, the CPI target of 2% will either be raised or abandoned.

The consequences for gilt-edged fixed income bonds will be calamitous - though the Bank could launch another round of quantitative easing to limit the damage in the short term (thus risking even worse problems further ahead).

Better news

A rosier scenario, however, could prevail: commodity prices, including the oil price, could fall back and the private sector could achieve reasonable growth. The Bank could start to raise short-term interest rates, which would be regarded as a demonstration of official confidence. The gilt-edged market would be reasonably stable and equities might stage a good rally.

It is a very testing time. The smartest investors keep their nerve: the way to make the most money in the long run is to buy when the situation looks grim and sell when everything seems rosy. Fortune favours the brave and the brave make fortunes. But it is not a strategy for the fainthearted.

Most of us prefer to hedge our bets. The advantage of a broadly-based equity portfolio is that it gives us a link to the global economy, including the developing countries, and offers some protection against further weakness of sterling.

Emerging markets, however, have had a poor few months. Yet the long-term arguments for a portfolio shift towards emerging markets remain valid: it is all a question of good timing.

To keep 10% portions of a portfolio in gold - probably through exchange traded funds - and inflation-linked government bonds remains a sound tactic.

These are backstop assets for difficult times, and are vital when money loses the second of its two functions: as a means of exchange and a store of value; when, that is, the Bank of England loses respect for sterling.

The verdict

The uncomfortable truth is that, after several years of official financial mismanagement, what should be the first asset of choice in a personal portfolio - liquidity, that is to say short-term bank deposits - has become the last resort. Official policies have driven investors towards riskier assets such as equities, corporate bonds and long-term gilt-edged securities.

The effective cost of comfortable liquidity has become 4% or 5% a year in real terms as inflation has accelerated. Nevertheless, it may, in some periods, still be worth paying such a price in order to avoid exposure to a nasty crunch.

Certainly, I would be happier at the moment in short-term deposits than in long-term government bonds where solvency crises are approaching. But portfolios diversified across global equities, commodities and property offer the best chance of wealth preservation looking a few years ahead.

This article was taken from the April 2011 issue of Money Observer.