How to beat inflation: bonds and equities

16 October 2012

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?


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

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