Central banks around the world view a low and stable inflation rate as a desirable ingredient for a functioning economy. In the UK, the Bank of England (BoE) has an inflation target of 2% and has been chasing this elusive economic variable for the past couple of years; inflation fell below the target in January 2014 and has been steadily falling since (the BoE considers inflation below the target to be just as bad as inflation above the target). However, inflation is making a comeback! As Hetal illustrates in her post, there are a number of factors in the UK which are expected to cause inflation to overshoot the BoE’s 2% target.
Rising prices are likely to have a negative effect on savings and investments, but unfortunately the dangers of inflation are often overlooked by the majority of individuals putting money away. Inflation erodes the value of nominal returns and it is therefore misleading to consider investment gains in isolation to the inflation rate. Investments need to grow in real, and not nominal, terms.
This leads us to the question: are you a sitting inflation duck? In other words, are your investments vulnerable to inflation? If yes, it might be time to consider assets which offer protection against inflation. These asset classes are referred to as real assets and include the likes of equities, property, infrastructure, inflation-linked bonds and commodities, to name a few. Asset classes which do not offer protection against inflation are assets which pay a fixed rate of interest, with cash being the most common one for most individuals.
As an illustration, the chart below compares a few investments over the last nine years and highlights why it is important to consider the effects of inflation on their growth rate. An investment results in an increase in net worth at the end of nine years if it is higher, in real terms, than the starting investment of £100.
From the chart above, three investments end up higher than where they started. They are cash, a diversified mix of assets and UK equities. It might be tempting to choose cash as an investment due to the stability of returns and regard asset X as the worst possible investment.
However, cash shown here is in nominal terms and we know that it is crucial to consider investments in real terms. You therefore should ask how cash fared in real terms.
Well, asset X is cash depicted in real terms; our £100 investment is only worth around £90 after nine years. Unbelievable? Actually, not really…
Cash is a wolf in sheep’s clothing. Although it is perceived as a stable investment, it can be a risky investment as returns are needed just to keep up with inflation. People putting money away for retirement should not forget that the stability of returns provided by cash is not the same as being risk-free since they have a long time horizon and need returns above inflation. This problem has gotten worse in recent years as the real interest rate available on cash has dropped below zero in the wake of the financial crisis.
With inflation returning to the UK, cash is expected to perform worse in real terms, causing real returns to fall at a faster pace than has been the case recently. Given that we do not have a crystal ball, it is important that investors not only diversify their investment exposure, but also ensure that they have exposure to real assets which have helped to guard against inflation over time.
I am not a sitting inflation duck and I hope neither are you. Get real before it is too late!