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It was the publication of stronger-than-expected employment data and the first real evidence of rising wage inflation in the US last month that unsettled the chickens in the market coop. High valuations combined with automated trading programmes only served to accentuate the volatility seen in markets round the world after a long period of calm and steadily rising indices. In fact, rising bond yields in mid-January had already begun to flag up what the figures are confirming: inflation is on its way and interest rates are set to rise in response to the threat.
Inflation may have dipped slightly this month (as measured on a ‘year-on-year’ basis), but it seems that a whole generation may have forgotten what inflation, that ‘thief in the night’, really means. After all, it has been a long time since the destructive double-digit inflationary times of the Seventies and early Eighties. But even a fairly modest inflation rate can devastate your purchasing power. For example, consider a basket of household goods costing £10 in 1974; to purchase the same goods today you would need £108 in your wallet. Or in percentage growth terms, your money would have had to have grown at an average of 5.5% a year just to keep pace with inflation.
Another easy way of working it out is to divide the inflation rate into 72. The answer will show you the number of years it takes to halve the ‘real’ - or purchasing power - of your money. So, if inflation were to double from its current 3% to 6% p.a., you would lose half your spending power in twelve years – a sobering thought.
As regards investment portfolios, inflation acts as drag on both shares and bonds and pulls in the opposite direction to the benefits of compounding growth. For example, the benchmark 10-year Treasury gilt has provided 4% real returns when inflation is in decline but a small negative real return when it is increasing.
So what can an investor do to combat the corrosive effects of inflation? If rising inflation is, in effect, a reflection of rising demand in an economy, then things like commodities and natural resources tend to respond with rising prices and therefore those that produce them with rising profits. Property stocks tend to do well in an inflationary environment, too, as rising rents feed rising share values. Infrastructure funds should also do well in these times because often the underlying contracts are index-linked and so the income paid out in return for the supply of the infrastructure asset will rise with inflation. Similarly, index-linked bonds can help insure a portfolio against the ravages of inflation. But it is worth bearing in mind that if inflation remains subdued, then these type of assets will underperform. So it is important to get the balance right.
At Church House, where clients value real capital preservation high among their investment priorities, we have been quietly building inflation protection into the funds that form the core building-blocks of their portfolios. For example, our core bond fund (CH Investment Grade Fixed Income) now has over 30% exposure to Floating-Rate Notes (FRNs), specialist institutional instruments whose pay-rate is re-set every three months and which will therefore benefit as rates rise.
Similarly, the Tenax Absolute Return Strategies fund has a significant exposure to infrastructure funds which provide a good hedge against rising inflation. Some equities also do well in certain inflationary environments, especially those related to constant consumer demand (consumer staples), financials, energy stocks and so forth. We tend to avoid gold in all environments because of the opportunity cost of holding it and the basic lack of an income yield. There are many who will cite gold as a good hedge against inflation and it is true that gold has usually risen in value as some investors will always flee for the seeming solidity of this safe-haven asset. We just prefer holding something that at least pays our clients something to hold it, whether a dividend or an interest coupon.
The worst asset to hold in inflationary times is cash. Even during the last ten years when we have been living in and out of a deflationary environment, cash held on deposit offering virtually zero interest, has lost nearly 30% of its purchasing power. And that is before you factor in its fall against other currencies, especially after the Brexit vote of 2016. At Church House, we always advise maintaining a contingency fund in cash to avoid the need to raid a portfolio at inopportune times in the market cycle. But the opportunity cost of holding too much cash – offering a negative real rate of return because of crushingly low yields offered on deposit – is still at the worst levels seen since financial crash of 2008/09.