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There have been at least two reactions to the pandemic in 2020 – increased government on the one hand spending, and more money printing by central banks on the other (increasing their balance sheets). Some people are concerned about this since it’s possible that it could lead to a much higher rate of inflation. This, in turn, could eat into the real value of investment returns and destabilise the wider UK economy. Yet the evidence to date is that inflation seems to be holding steady at a low historical rate. Moreover, there is also the chance that hugely reduced consumer demand post-lockdown could lead to deflation – which carries its own consequences.
So, could we be facing inflation or deflation in the coming months of 2020? Regardless, how might each scenario affect your financial plan, and what might you do to prepare now for either one? Our financial advisers offer some thoughts in this article to assist. We hope you find this content helpful, and invite you to contact our team here at Cedar House for more information or to access personalised financial advice:
020 8366 4400 or email@example.com
Inflation and financial planning
It’s helpful to first remind ourselves about what inflation is and how it works. Suppose you want to buy a loaf of bread. If you look at the price over time, you’ll see that the price generally rises. In the USA, for instance, the price of a loaf of bread has risen nearly 400% since the 1980s. The change is usually measured annually, so a 2% rate of inflation in 2019, for instance, means that prices have generally risen by 2% in that year. If the Bank of England (BoE), say, states that the figure is something like -2%, then it means that in this year prices have fallen by this amount.
Various forces can cause inflation. During a period of strong economic growth, for instance, a rapid rise in wages can drive inflation. As people have more to spend, demand for goods and services usually increases – raising prices. Another factor can be rising input prices, which represents the costs that businesses must pay to operate profitably (e.g. increased wages or oil prices). Another force can be currency depreciation. A fall in the value of the British pound, for example, increases the cost of importing goods/services from trading partners. Finally, low unemployment can also drive inflation since workers are in a stronger position to demand higher wages from employers.
How might this affect a financial plan? In the short term, of course, rising inflation can lead to higher monthly bills (e.g. energy and food). Longer-term, moreover, it can represent a threat to your investment growth if not managed carefully. If your average annual returns from your portfolio is 6%, for instance, yet inflation rises to 7%, then in “real terms” your wealth has contracted in value by 1% – even if, on paper, it looks like your wealth has grown.
Deflation and financial planning
Whilst prices generally rise over time, sometimes they fall within a given timeframe (deflation). This increase in the “purchasing power” of the price of money might happen for a number of reasons. One might be due to a shortage of money in circulation within an economy. Another may be that more goods and services are produced than there is a demand for. The overall impact on an economy, regardless, is generally not good. This is due to the “deflationary spiral”, which can start at any point but which can have the following effects:
- Rising unemployment (e.g. due to an economic shock).
- Lower demand for goods and services.
- Deferred consumption as consumers watch prices fall, waiting for a better deal.
- Oversupply and price falls.
- Lower corporate profits due to falling revenue from reduced demand.
- Companies defaulting and more bankruptcies.
The above clearly have big implications for financial planning. If you lose your job due to your employer going bust, for instance, that’s not a good outcome. Yet deflation can have a mixed impact upon your investments. On the one hand, cash investments might see an increase in returns as interest rates possibly beat the rate of inflation. Lenders (e.g. those buying government bonds) also could benefit, as the principle grows in purchasing power. Yet higher default rates amongst companies is likely to increase credit risk. Borrowers, moreover, find it more difficult to service debt during a deflationary period, and inflation-linked bond investments are also likely to suffer.
Inflation or deflation in 2020 – which will happen?
So, what will happen in 2020 or 2021? Will the UK see an increase in prices as the BoE keeps increasing the money supply? Or, will deflation result – perhaps due to falling consumer demand in the wake of a second lockdown later in the year?
Nobody knows, of course. Yet fortunately, there are ways to prepare your financial plan so that it accounts for both possibilities. Ensuring an appropriately-diversified portfolio will be one key step, for instance, as will laying the groundwork for an effective financial protection plan.
If you would like to discuss your financial plan with a member of our team, then get in touch today to arrange a free consultation:
020 8366 4400 or firstname.lastname@example.org.