How do I protect my investments from inflation?
How do I protect my investments from inflation?
As we know from our previous article, inflation is the rising cost of goods and services and the associated loss of purchasing power of cash. Conversely, deflation is when prices are falling and there is an improvement in the purchasing power of cash.
On the face of it, one may assume that being able to purchase more one year than the previous year with the same amount of cash would be a good thing, however, given that the majority of the world’s economies run on debt, deflation can make it more difficult to service debt repayments. Deflation can also reduce the number of jobs and put pressure on the financial system as a whole. As a result, governments generally strive to keep economies running at a low level of inflation. In the UK, the Government has set the Bank of England an inflation target of 2%, with an allowable range of between 1% and 3%. If inflation falls outside of this range, they must write to the Government and explain their plan of action to return inflation to the 2% target.
These letters are available to read on the Bank of England website.
What is causing the current period of high inflation?
In the Bank of England’s most recent letter to Rishi Sunak, the Chancellor of the Exchequer, they have outlined some key inflation factors:
The price of global energy, exacerbated by the conflict in Ukraine.
The price of global core goods after the pandemic, heightened by the demand switch to goods from services and the impact that lockdowns in China are having on their ability to meet this demand.
The tight domestic labour market, which has increased the cost of UK services.
The domestic pricing strategies of UK firms.
A succession of shocks to the economy such as Brexit, the Pandemic and the Ukraine conflict.
As a result of these pressures, the Bank of England’s outlook for inflation does not paint a rosy picture. At the time of writing (June 2022), the UK inflation rate is 9% and is expected to rise to over 11% by October once consumer heating systems are turned on again and the price of food increases. Additionally, it is forecast that inflation will peak higher and last longer in the UK when compared to the USA and Euro Area.
The main lever that the Bank of England can pull to combat inflation, via Monetary Policy, is to raise interest rates, which they have been doing with increasing frequency over recent months, albeit from a historically low level. The Government, on the other hand, can use Fiscal Policy to offer support to households, and supply-side reforms to ease inflation, such as increasing energy independence and offering labour market reforms to encourage skilled migration. In his response to the Bank of England’s letter, Rishi Sunak has also hinted at tax cuts and reforms to encourage investment, training and innovation.
The key takeaway from these letters is that high inflation is likely to be with us into the mid-term and that we must all take steps to protect the value of our investments and ability to face the rising cost of living.
How does inflation affect the value of your investments?
A fluctuating interest rate can have an unpredictable impact on the value of your investments, but the impact can be most greatly felt in relation to fixed-rate debt securities, such as bonds and gilts, as inflation erodes the repayment and makes them less desirable in the market.
In order to best understand the actual return of a fixed-rate security, one needs to focus on the real interest rate by subtracting the current inflation rate from the nominal interest rate. Given the historic low interest rates of recent years, deducting 9% from almost any nominal interest rate will likely result in a negative result.
Conversely, the investments that perform the best during periods of high inflation are those that rise in value or generate more income, in line with inflation. Examples include rental property that is subject to upwards-only rent reviews or investments in infrastructure projects where income is tied to inflation.
How is property affected by inflation?
Property is often seen as the default investment choice during periods of high inflation as it acts as both a rising store of value and generates an inflation-linked income. Investors may opt to purchase property as an individual, as a business or via an investment vehicle such as a Real Estate Investment Trust (REIT) or property fund.
Although property has fared well in the previous periods of high inflation, affordability and rising interest rates may have an impact on the ultimate growth potential in the future.
How are commodities affected by inflation?
Rising inflation often pushes investors towards tangible assets such as gold and other precious metals as an increase in demand may increase the value of the asset over time. Gold can be purchased as a physical asset from a bullion dealer or indirectly by investing in a gold fund.
Investing in commodities in a broader sense, such as in agricultural products and oil, can be more complicated as prices/values often reflect contracts made in the past.
How are bonds affected by inflation?
As previously mentioned, fixed-rate debt bonds may be negatively affected during periods of high inflation. However, the opposite is true for inflation-linked bonds as, by their very nature, they are designed to track inflation. An example of an index-linked bond is a UK index-linked gilt that can be obtained by purchasing units in an inflation-linked bond fund.
How are shares affected by inflation?
Shares have the potential to perform well during periods of high inflation, however, the opposite is also true as it all depends on the company in question. It may be the case that dividends are reduced as companies need to hold back more cash to cover rising costs. Equally, if a company has yet to secure funding to achieve its growth strategy, the cost of funding will increase and may result in a less profitable operation.
Conclusion.
Adjusting your investment strategy to account for periods of high inflation takes careful consideration and should be undertaken alongside your financial adviser. The primary goal is to retain the value of your portfolio in real terms as the likelihood of increasing the value becomes more difficult. Overall, a diversified portfolio could work best as it spreads risk and the potential for growth over different sectors and asset types. However, it’s essential to not lose sight of your tolerance for risk and long-term goals as simply focussing on inflation-proofing your investments could ultimately limit your capital growth over time.
The most important thing to remember though is that there are no dead certainties and that economic conditions can change overnight. As a result, strategies that may have worked in the past may not work again so always seek advice from your qualified financial adviser before making any decisions.
What’s next?
If you need help or advice on your personal or business finances or if you want to consider investing to make your money work harder, you can get in touch with one of our advisors for independent financial advice. We offer a free initial consultation and although we are based in Tunbridge Wells, we advise clients across the UK.
Don’t forget, this article offers information about investing and should not be taken as personal advice. Remember that investments and pensions can go up and down in value, so you could get back less than you put in. Tax rules can change and the benefits depend on individual circumstances.