Inflation, once considered dead, is making a fierce comeback. As costs creep up and the pound in your pocket is worth less than it was, we take a look at what this means for savers and investors, as well as which investments have demonstrated some resilience to this phenomenon in the past.
What is inflation?
Put simply, inflation is the increase in the price of the goods and services we purchase. Some of those purchases are made by choice, such as holidays and dining out and some are not, such as electricity and gas.
In an environment where inflation is rising, our ability to buy products and services (also referred to as purchasing power) diminishes and the rate of inflation determines how quickly that happens. Fuel prices at the pump are often used in the press to express how inflation is impacting purchasing power. It’s a good example, as it highlights our reliance on fuel while shining a light on how rising prices can impact our behaviour in other parts of our consumption.
The fuel price at the pump in June 2021 was 129.52p, on the 22nd of June 2022 it was 187.51p. To put that into context, filling the average UK car up in June 2021 would have cost £77.71, whereas today that would cost £112.51. A difference of £34.80. This is a clear example of our purchasing power diminishing as a result of inflation, you can’t buy as much fuel with your money today as you could last year.
If your wages aren’t rising at the same pace of inflation (which is the case for most of us) then you are faced with making choices about how to budget your income: what is essential versus what you can do without. Some may use credit or borrowing to maintain a level of living standards, others may dip into saving, while some may make cutbacks.
Why is inflation such an issue right now?
We are in a perfect storm as inflation is rising at its fastest pace in 40 years. On the 22nd June 2022, the Office of National Statistics (ONS) reported inflation at 9.1%, the highest since 1982, when it was at 8.61%. COVID-19 and the impact it continues to have on the supply of goods and services has seen demand force prices higher. The war in Ukraine and sanctions applied on Russia have led to a lower supply of some commodities, particularly oil and grain. This has only added to the problem of a low supply and high demand. And the rising oil price feeds through into everything else.
These market forces are catching people and business out, due to the pace of rising prices against lacklustre wage rises. The ONS recently reported that UK wages rose at a pace of 4.2%, excluding bonuses between February and April 2022, which is less than half the headline rate of inflation in the year to May 2022, which was reported at 9.1%.
What does this mean for savers and investors?
For cash savers with deposit accounts, wealth is being aggressively eroded by inflation. The best deposit rate fixed for one year according to Moneyfacts.co.uk was 2.20% on the 22nd June 2022. With inflation at 4x that, savers are currently losing out to inflation by around 7% in future purchasing power. That is a big gap by any standards.
The picture is much more mixed for investors in the stock market, as returns will be dependent on what types of assets investors are exposed to. There are assets which do a better job than others at inflation-proofing wealth. That said, markets can change direction at any time, so think carefully before putting all your eggs in one basket and jumping on the inflation-proofing bandwagon. While inflation is impacting the cost of living right now, that impact is changing consumer and business behaviours. This, in its extreme, could lead to a deflationary bust where cash and other such investable assets would once more have their moment in the sun.
As we know, we are all built differently, and this is no different when it comes to making decisions about saving and investing. We will have different risk tolerances, different demands on our capital, we are at different life stages and have different lifestyles. Whilst past performance is not a reliable guide to future performance, over the long-term, if you are in the fortunate position of being able to ride the ups and downs of the stock market, it has historically produced higher returns than keeping your money in a savings account. But as always, avoid short-term debt and make sure you have sufficient cash in the bank to meet those rising costs so that you aren’t forced to sell out of the market in the short-term.
What types of investments can be inflation-proof?
There are some assets that try to provide more protection from inflation than others. For example, inflation-linked bonds and absolute return funds, as well as infrastructure, property, and commodities.
Property is one of the more common asset classes that can provide some protection against inflation. Landlords tend to increase rents in certain economic conditions, pushing property values up and commercial property will often have rent increases baked into lease contracts. And often leases go as far to specify that rent can be adjusted upwards only.
Inflation-linked bonds, unlike a conventional fixed rate bond where the coupon or interest rate is fixed, will see the coupon rise with inflation. This can be particularly useful to those reliant on an income from their investments.
Absolute return funds that use long and short investing strategies could be another option. If a fund manager can short a stock or asset (a bet on falling asset values), that enables them to pull levers that other managers who can only go long (a bet on rising asset values) can’t. This extra flexibility means that they may avoid some of the risks that are present in the market. However, shorting comes with a long list of other risks so once again, there is no risk-free golden ticket.
Infrastructure is another asset class (sometimes included under the alternative assets umbrella) that can protect against inflation. This is because these assets tend to have long-term predictable operating cash flows that usually have inflation-linked price increases baked into operating contracts. These prices are then directly or indirectly passed on to customers.
Another popular area is commodities, particularly gold and other precious metals. Gold is often touted as the ultimate inflation hedge. Those considering it should know that it can be a volatile asset with many competing factors determining its price.
In general, commodity prices tend to rise as inflation accelerates, this is because they are the raw material inputs of the products and services experiencing rising demand. In fact, commodities have experienced some notable price increases due to supply constraints following the impact of COVID-19, the war in Ukraine and rising demand of the actual commodities.
So what about equities? Well, in theory equities should do well in an inflationary environment. Though this is dependent on lots of factors, including the ability of the underlying company to be able to pass on rising costs to the end customer. Within equities, Growth style investing tends to be more negatively impacted in high inflationary environments due to rising interest rates, whereas Value style investing has historically done better in these environments. The reason for this is that in an inflationary environment where interest rates are rising to combat inflation, Growth stocks can come under pressure if a greater proportion of their value is reliant on future earnings. Value stocks on the other hand tend to have more predictable near-term cash flows. Banks, for example, benefit from rising rates because they can take advantage of the difference between the interest they pay over what they can earn from investing customer deposits.
Is everyone impacted the same by inflation?
Simply, no. We all have different demands, often dictated by our life stage and the impact of rising prices can therefore also vary. Inflation is often defined as the average price rise by the average consumer and for some of us that rate may well be higher or possibly lower than the one published. Some groups in society can be affected disproportionately, such as lower income households as they may have to spend a higher proportion of their income on necessities.
Conclusion
There is no one right way to invest to meet the challenges of inflation, but some assets, like the ones mentioned earlier, have historically provided better protection against inflation than others. Understanding your personal circumstances and budgeting to meet them should be your first priority. Beyond that, building some inflation protection into your portfolio will have its merits. The important thing is to make sure whatever changes you might make, they remain suitable to your overall investment goals and objectives.
Date of publication: 29 June 2022
The information in this post is not financial advice, it is provided solely to help you make your own investment decisions. If you are unsure about whether an investment is appropriate for you, please seek professional financial advice. You can find more information here.
When you invest you should remember that the value of investments, and the income from them, can go down as well as up and that past performance is no guarantee of future return.