In the current disinflationary environment the threat of inflation may appear to be a minor concern, but those who recall the impact of inflation in the ’70s will be mindful of its potentially lethal impact on savings pots.
While those still in employment are likely to be protected as their wages rise, those reliant on savings and pensions income are all too vulnerable.
Even a modest level of inflation has a corrosive effect on purchasing power, particularly if it is compounded over an extended period. An inflation rate of 7% will act to halve a pensioner’s spending power over the course of a decade and double digit inflation rates can swiftly wipe out those living on fixed incomes.
Recent retirees, or those just about to retire, are the most vulnerable to the effects of inflation. For these people, capital bases are at their highest and time horizons at their longest. Understandably, one of the key outcomes that clients in this position will be looking to achieve is a degree of inflation protection.
Unfortunately, this is one of the more challenging tasks to meet for an adviser.
Firstly, the adviser should consider what liability he is looking to offset. Are RPI or CPI really the most appropriate inflation benchmarks for those facing retirement?
Saga has been monitoring inflation rates across different age groupings, and their analysis has consistently shown that inflation rates vary across differing demographics.
Levels of household wealth will also influence spending patterns and this will be reflected in individuals’ personal liabilities. For example, wealthy retirees may be impacted by the cost of foreign holidays while those on more modest means will be more troubled by gas prices. These are all factors that advisers should be considering.
UK investors are fortunate that there is a well-established government index linked bond market. Unfortunately, it is a little too well established and too popular with investors – yields have shrivelled and it is no longer possible to find government backed bonds that will produce returns that will exceed, or even match, inflation.
This has done little to diminish institutional demand and much buying seems to occur regardless of price. Nevertheless advisers may feel that some exposure may still be warranted and there are a wide range of funds in the sector.
BlackRock and Vanguard are usually two good places to start when looking for good passive funds, while for those seeking active management, Square Mile likes the team behind the Royal London Index Linked Gilt Fund.
However, we fear that investors could be in for a shock if inflation begins to pick up materially, as these funds could generate significant short-term losses. Nominal gilt yields will climb as inflation accelerates, and historically real interest rates have moved in the same direction as nominal yields.
It is conceivable that linkers funds could underperform, even versus conventional gilt funds, if inflation becomes a problem. Double-digit losses are not inconceivable, given the very high level of duration that these funds run.
Equities may also be considered as an option. While they have maintained their value in real terms, this is only true over long time horizons; equities have historically performed poorly during periods of rising inflation.
The reasons for this are unclear but may relate to a rise in the discount rate used in their valuation. Equities are a long duration asset that will suffer if real interest rates climb. Rising inflation also creates economic uncertainty, which too will increase the discount rates that underpin valuations.
Over the medium to longer term, equities should become a better store of wealth as valuation metrics stabilise and companies adapt better to the inflationary environment.
We believe that companies with high levels of reoccurring sales, strong returns on equity and that are cash generative should hold up better than others. These are the types of stocks favoured in the strategies followed by Lindsell Train UK Equity and Jupiter European.
An asset class that is traditionally considered as an inflation hedge is gold.
History shows that it is one of the few assets that performs well during periods of rising inflation. Of course, it has little function in our modern economy and only has value thanks to its antediluvian heritage. But if credibility of fiat money begins to slip, some exposure may make sense.
Today, there is little necessity to hold physical gold and there a number of ETFs that provide solid passive exposure. Gold shares may also be considered and funds such as BlackRock Gold and General may prove suitable.
Though we should add a word of caution about gold. Its price has risen five fold over the last fifteen years, a period notable for disinflation rather than inflation. Evidently the price of gold has great sensitivity to factors other than inflation, and this, in our view, rather limits its appeal as a hedge.
