The time may have come to get comfortable with riskby / February 19, 2018 / Leave a comment
The last time the inflation rate in the UK touched its current level was during the early months of 2012—and then it was on its way down. In the intervening years, we became much more accustomed to seeing price rises slow to a crawl than gallop ahead, to the extent that inflation even fell to zero throughout much of 2015. For a few brief months, Britain experienced something hitherto almost unimaginable: prices that neither rose nor fell, but which stood still.
It is no coincidence that, after adjusting for changes in the cost of living, 2015 also saw real wages grow at their fastest rate since well before the financial crisis of 2008: not because pay rises became more generous, but because price rises temporarily vanished. Not for long. In the months before the European Union referendum, inflation started to creep back in and as the result of the vote became clear through the small hours of Friday 24th June 2016, the pound immediately shed around 20 per cent of its value against our major trading currencies. At a stroke, everything we needed to buy from overseas—food, manufactured goods, raw materials, oil—became much more expensive. Since then, inflation has not only risen from the dead. Fuelled by Britain’s gargantuan appetite for imports, it has taken up sprinting.
Abrupt though the turnaround has been, it is entirely possible that the pace of price increases may slow during 2018 as sharp price rises in the months following the referendum start to drop out of the year-on-year comparisons. But even if the rate of inflation falls back, the price of almost everything we buy will be significantly higher than 18 months ago. With wages still growing much more slowly than prices, the squeeze on the average household’s spending will continue to tighten. Now that the base rate has started to rise again, albeit in small steps, pressure on disposable incomes will gradually intensify as higher rates feed through into mortgages and rents.
How should investors approach this unappetising situation?
The first point is obvious enough but often ignored. The reappearance of inflation is a reminder that we need to focus on “real returns”—factoring in inflation—not nominal returns that take no account of it. This is easier in some cases than in others. Fixed income products such as deposit accounts or bonds pay a specified annual rate of interest that enables us to see exactly the return we are going to receive. This makes it straightforward to compare it with the inflation rate and to see what, if anything, is left over.
But in other areas it can be harder to discern the impact of inflation and we are liable to be fooled by our own assumptions. Residential property is a great example. The BBC recently published a piece of research carried out with the Open Data Institute that looked at house price increases in every council ward across England and Wales between 2007 and 2017, and adjusted the data to account for the effects of inflation.
“The price of almost everything we buy will be significantly higher than 18 months ago”
In 58 per cent of council wards, house prices had fallen in real terms over the previous decade. The only regions to show relatively consistent price increases in real terms were the south and east of England. The BBC reported that, after adjusting for inflation, average prices across Wales, Yorkshire and the Humber, the northeast and the northwest, had fallen 10 per cent since 2007. So much for the notion that ultra-low interest rates and quantitative easing push up asset prices—some more than others, evidently. So much also for the idea that investing all you can in property is as close to a one-way bet as you can get: it all depends on location, location, location. And so much for cheery headlines that announce house prices across the country are rising by two or five or 10 per cent a year—not necessarily around here.
Given that wages have been growing so slowly for so many people, it probably should not come as a surprise that house prices in so many parts of the country have failed to keep up with the cost of living—how are buyers supposed to afford them? But the fact that a report like this still appears so counter-intuitive provides a powerful reminder of how difficult we find it to incorporate inflation into our view of asset prices and returns, and how unthinkingly we cling to popular articles of faith such as the inevitability of making money from property.
As an investor, the most helpful way to look at inflation is as a form of risk—the risk that over time my gains will fail to keep up with the increase in my costs of living. Of course, as savers and investors we can never escape risk, so we must learn to live with it. The known risk of losing money gradually through inflation is frequently preferable to the unknown risk of losing it suddenly in some financial market shock. This helps to explain why many people, for perfectly good reasons, choose to keep money on deposit even though the interest rate they are earning is well below inflation, and why sophisticated, professional investors still buy super-safe government bonds with yields that are lower than the rate of inflation. Safety and certainty—even of limited losses—very often trump all other considerations.
If inflation is a risk that we need either to accept or offset, then final salary pensions are probably the best way to mitigate that risk. A final salary pension takes the lion’s share of our future inflation risk and passes it to our employer’s pension scheme—and ultimately to the company that stands behind the scheme. This is an amazing (and probably never to be repeated) deal for those old enough to have joined one. And it is at times like this, when final salary pension entitlements are being upgraded in line with sharply higher inflation, that those tempted to transfer their money out—and surrender forever that lifelong protection from inflation risk—should look twice before they leap.
There are perfectly good reasons to pull your money out of a final salary scheme, such as reduced life expectancy due to ill health, for example. But for most people, it remains a bad idea. The Financial Conduct Authority recently said that, in more than half the cases it reviewed, the advice people received on transferring out of a final salary pension scheme was not “suitable.” That comes as no surprise. The peril is easy to understand but still extraordinarily hard to resist: the allure of an immediate lump sum blinds most of us to the slow-burning damage to our wellbeing that comes with decades of rising prices.
This highlights the major issue that we all have to take into account during times of rising inflation: that we are almost certainly going to have to take more risk of other sorts if we want to achieve inflation-plus returns because the safest options, such as cash and high-quality bonds, cannot meet our needs.
The classic investment answers to the inflation challenge are to offset it by taking two other sorts of risk: equity risk and liquidity risk.
Shares traditionally offer at least some protection against inflation to the extent that companies have “pricing power”: the ability to raise their prices and so protect their profits and returns to shareholders. Research by the London Business School academics Elroy Dimson, Paul Marsh and Mike Staunton, suggests that returns on equities after inflation do not start to decline seriously until the rate reaches about 8 per cent, well above current levels.
Investing in equities is therefore a well-established way to create above-inflation gains—over the very long term, shares have returned 5 per cent a year in real terms, according to the annual Barclays Capital Equity Gilt Study. That said, shares are volatile, as the recent correction has shown, and subject to short-term influences of all sorts. At the moment, we need to be careful in looking for opportunities in the stock market because the hard-pressed consumer is bringing problems to areas well beyond the expected trouble spots such as retailers. For example, listed utility companies have typically been a reliable if unspectacular staple of defensive, income-producing portfolios. But growing political pressure to protect stretched households has raised the threat of price caps and even nationalisation, making them a much less attractive proposition for investors and therefore hitting their share prices. Political risks of this sort rise sharply when people’s incomes are being squeezed.
But political intervention can also work in your favour. Housebuilders look a decent long-term option thanks to the government’s determination to carry on stoking demand through the Help to Buy scheme. Investors should generally welcome opportunities to piggyback on official attempts to rig the housing market.
“I would favour low cost funds that focus on large European and Asian companies”
Other key attributes to look for would include companies that do significant amounts of business in international markets, especially since much of the world economy beyond the UK’s shores appears to be enjoying a pick-up in economic growth coupled with generally low inflation. Almost half of the global fund managers that responded to the latest Bank of America Merrill Lynch poll expect above-trend growth and below-trend inflation, wrote Philip Coggan in the Economist’s Buttonwood blog. “That is the highest proportion recorded in the history of the survey,” he added, a sharp turnaround from recent years when many believed both growth and inflation would be below their long-term trend. Belief in the so-called Goldilocks economy (neither too hot nor too cold, but just right) is reviving.
There are straightforward ways for UK investors to gain exposure to the improving international outlook. The UK’s FTSE 100, and to a lesser extent the FTSE 250 index, contain a lot of companies that earn a high percentage of their sales and profits in overseas markets. These tend to be less affected than the UK by very slow wage growth and high inflation. Beyond our domestic markets, I would favour low-cost funds that focus on large European and Asian companies that are well diversified internationally and ideally have some pricing power in their markets.
The second main way in which investors tend to offset inflation risk is by investing in so-called “real assets” such as commercial and residential property, and infrastructure (everything from roads and power grids to solar energy farms and mobile masts), and in “private markets” such as private equity funds and direct lending to companies. These all have the potential to provide strong real-terms capital gains and/or income yields that are well above the rate of inflation. Returns on commercial property and infrastructure tend to have a degree of linkage to inflation through the rental increases built into their leases or the terms of their operators’ contracts with governments and local authorities.
The major difficulty with assets of this sort is that they are typically illiquid, meaning that it can take time to sell them and get your money back. If you do sell, you may have to accept a lower price than you might have hoped for to get out quickly. The premium they typically offer over returns from more traditional investments represents the compensation on offer for accepting this illiquidity risk. In fact, private investors are usually able to access illiquid assets such as these through listed specialist investment trusts, which overcome some (but not all) of the problem with illiquidity.
There are well-established ways for investors to counteract the effects of rising inflation, but they are mostly things that they should be doing in any case: seeking long-term exposure to equities for positive real-terms growth, and putting money they can afford to tie up for long periods into illiquid assets to earn the “illiquidity premium” these opportunities can offer. Whether you choose to invest in specialist funds or cover a broader range of investments via so-called multi-asset funds, the key point remains the same: inflation is just another fact of life that investors must budget for. But if you wait until the papers are full of stories about it, the cost of protecting yourself is likely to have gone up a good deal—that’s inflation for you.