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The cost of living never stands still. Goods and services usually rise in price over time (inflation) or, sometimes, go down overall (deflation). This dynamic in the economy has big implications for your money. After all, if £1 today cannot buy as much in 10 years’ time due to the rising cost of living, how can you be sure whether your savings – especially those set aside for retirement – will be enough to achieve your goals?
This whole subject – inflation and retirement planning – is often overlooked by people. Below, our team at Cedar House outlines how inflation can impact your investment strategy, and suggests some ideas that can keep you moving towards your financial goals.
We hope you find this content useful. If you’d like to discuss your own financial plan with us, please contact our team for more information or to access personalised financial advice:
020 8366 4400 or enquiries@cedarhfs.co.uk
How inflation works
Inflation is broadly defined as the measure of how quickly prices are rising for goods (e.g. a loaf of bread) and services (e.g. internet). It is calculated differently across countries, but in the UK it is measured using the Consumer Price Index (CPI) – sometimes also called the Harmonised Index of Consumer Prices (HICP). The CPI imagines a “basket of items” which someone might commonly buy – using 180,000 price quotations from various retailers – and calculates their price movements over time.
If the overall price movement of this basket is quite sharp – either very high inflation (e.g. 5% or more) or heavily deflation – then this is usually damaging to the economy. This is why the Bank of England (BoE) which controls UK monetary policy seeks to keep inflation at 2%. Over the past few years inflation has been quite low, sitting at 1.79% in 2019 and 0.85% in 2020. At the time of writing in July 2021, however, inflation has risen fairly significantly to 2.1%.
Inflation and bonds
Investors become concerned about higher inflation because it represents a “silent killer” on their returns. For instance, suppose your portfolio rises 6% (on average) over a 10-year period, yet inflation also averages at 3% during this time as well. In real terms, therefore, the value of your portfolio will have risen just 3% even though the “paper value” shows 6%. As such, it is often also in investors’ interests for inflation to be kept under control so that the buyer power of their investments is not eroded too much.
This is one reason why bond investors need to think very carefully about the bonds they include in a portfolio. Rising inflation will erode the buying power of a bond’s future cash flows (which hold steady even if the cost of living goes up). Moreover, generally speaking, the higher inflation currently is – and the higher it is expected to be in the coming months/years – the more yields will go up. This is because investors will demand this to make up for the higher inflation eating into their returns. As such, the timing of your bond purchase can matter significantly.
One way to mitigate the above is to consider buying inflation-linked UK government bonds. This helps to ensure your future bond repayments also rise if the CPI goes up. However, remember that the rate of return on these “linker” bonds is typically lower than “non-linkers”, so you may be hedging against a higher rate of inflation that never transpires.
Inflation and equities
The relationship between equity prices and inflation is less clear-cut than with bonds, but it is still significant. First of all, investing in stocks usually offers a higher rate of return compared to bonds because of the higher investment risk involved. For instance, if a company fails, then it must repay its creditors before it compensates shareholders. Assuming you have a higher risk appetite and longer investment horizon in front of you, however, then investing in equities can be a way to hedge against inflation.
Conversely, higher inflation can be detrimental to equities in the shorter term. Broadly speaking, as inflation rises stock prices are pushed down, but when inflation goes down stock prices are encouraged to go up. This is partly because higher inflation leads to higher “input costs” for a business (e.g. raw materials to make products), which then eat into the company’s profits. This may, in turn, lead the company to pay a lower dividend to shareholders – or even suspend it. For investors seeking capital gains rather than income from their shares, higher inflation can also be a negative force. After all, higher input costs leaves less profit to reinvest into the business and grow the company’s value.
Whilst equity investors cannot control the rate of inflation, there are ways to mitigate its impact on a portfolio. One option, of course, is to simply wait for inflation to go back to the BoE’s target of 2%. If you do not need the money right now, then you may not need to change strategy too much – only be patient. Another option, however, may be to include more inflation-hedged equity investments in your portfolio. These might include companies whose share prices are expected to hold reasonably steady during periods of higher inflation, or perhaps even rise (e.g. consumer staples – since people still need to buy food during hard economic times).
Conclusion
Interested in discussing your financial plan with an experienced financial adviser? Get in touch today to discuss your financial plan with a member of our team here at Cedar House via a free, no-commitment consultation:
020 8366 4400 or enquiries@cedarhfs.co.uk