The time may have come to get comfortable with riskby Andy Davis / 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.