Inflated Expectations

Inflation appears to be on an upward trend, no matter how you choose to measure it. The latest increase in the Consumer Price Index was 4.0 per cent, representing a nine-month high. The Retail Prices Index rose by 5.1 per cent. Remember that these are very much averages and, for many, the actual experience of inflation is even higher.

Conventional macro-economic theory would suggest that high inflation is not a good thing. It is usually indicative of the demand for goods and services exceeding supply. The conventional expectation is that the Bank of England would increase base interest rates in order to bring supply and demand back into balance. However, conventional is certainly not the way to describe the country’s current economic predicament. Although the UK has recovered from recession, the strength of the recovery is still relatively weak. It is also patchy.

If this is the case, you may ask: Why inflation is proving to be so persistent? One of the big factors has been the impact of weaker sterling. It has fallen by about 20 per cent on a trade-weighted basis over the last couple of years. An inevitable consequence is higher prices for imported goods. Also, it is important not to under-estimate the impact of tax rises.

There have been a number of increases in both direct and indirect taxation (VAT and fuel duty in particular) and it is thought that these could account for up to 2 per cent of the CPI increase. Tax is money removed from the economy (assuming the Government uses it to reduce debt rather than spend it), so whilst the tax increases may contribute to inflation, the actual effect should be deflationary.

I think that this may be good enough reason to leave base rates at 0.5 per cent for the time being. Nevertheless, expect rates to rise this year. The financial markets are already pricing in a rate rise during the summer.

Unfortunately, the short term outlook for deposit-based savers is not too encouraging. Rates of interest will rise, but not by much, and not very quickly. In addition, it is important to remember that banks and building societies will pass on as little of the rate rises as possible to savers as they are under pressure to increase profits and improve balance sheet strength. After tax, interest is likely to continue to fall short of inflation, leading to further erosion in the real value of capital.

Inflation is the silent assassin for deposit based funds. An inflation rate of 4 per cent per annum over 10 years would have the effect of reducing the spending power of money by a third. Over 20 years only a third of the spending power is retained (see chart). It is, therefore, essential that strategies for investment/savings over the medium to long term incorporate a degree of inflation protection.

Those with variable rate mortgages will continue to enjoy the benefit of low interest payments and are hopefully being prudent by banking this benefit rather spending it. Also, inflation is often a good thing for those with debt because it erodes the real terms value of the amount owed, assuming that the interest is properly serviced. For investors there are a number of issues that need to be considered at present. In anticipation of rising variable interest rates, investors should be reducing allocations to fixed interest investments (particularly Gilts) because prices tend to fall when variable rates rise.

One possible exception within the fixed interest asset class would be high yield bonds. These are inherently less secure than Gilts and investment grade corporate bonds. The risk of default is priced into values and this is why there are some very good yields available. As the global and domestic economies continue to heal, it would be reasonable for default rate expectations to reduce. This would lead to capital appreciation as yields compress.

Index-linked Gilts would normally look attractive at this stage in the economic cycle, but would appear over priced at present. Adding to other asset classes, such as equity and absolute return funds, would seem a better alternative over the medium term, assuming that risk is mitigated by an appropriate level of diversification.

Absolute return funds aim to consistently generate a positive return whatever direction markets move in. The methods of achieving this are complex; perhaps something I could return to in a future edition.

Equity investment needs to be diversified geographically. Forgetting the gloom in the UK economy, there are other parts of the world that are set to continue growth at an impressive pace.