W
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INFLATION MATTERS: THE IMPACT
OF RISING PRICES ON INVESTMENTS
by Sam Hulson of First Equitable
A pound saved is a pound earned. But thanks to inflation, over time, the
value of the pound saved could be much less than when it was earned.
One cannot ignore the corrosive impact of rising prices on investments.
Investors can easily fail to prepare for the risk of inflation eroding the
purchasing power of money, especially in a low-inflation environment.
Therefore, it is wise for portfolios to include assets that help offset the
effects of inflation.
MAINTAIN THE PURCHASING POWER OVER TIME
After two years when consumer prices in the UK barely rose, there are
signs that inflation may be about to return. If it does, how should you
prepare? To help maintain the purchasing power over time, your savings
need to grow at least as quickly as prices are rising. The Bank of England
forecasts that consumer price inflation will remain above 2% in each year
until 2021. While nowhere close to historic highs, higher inflation stands
in contrast to near-record-low interest rates offered on cash savings. Higher
inflation represents a hike in the cost of everyday living – and the higher it
rises, the less your cash will be ultimately worth.
BIGGEST ENEMY OF CASH SAVERS
Keeping enough cash aside to cover any foreseeable costs you might face is
always sensible (typically three to six months of your monthly outgoings).
However, relying solely or overly on cash might prevent you from achieving
your long-term financial goals, which may only be possible if you accept
some level of investment risk. Worse, in an environment where the cost of
living is rising faster than the interest rates on cash, there is a danger that
your savings will slowly become worth less and less, leaving you worse off
down the road.
SEEKING HIGHER INVESTMENT RETURNS
If you are prepared to take on some investment risk, you could look at
investing in a bond fund to look for higher returns. Bond funds invest in a
basket of IOUs issued by governments and/or companies looking to raise
cash. When someone invests in a bond, they are essentially lending the
bond issuer their money for a fixed period of time.
INVESTOR INCOME RISING IN LINE WITH INFLATION
Protection against this threat is offered by inflation-linked bonds whose
coupons and principal will track prices. By linking coupons to prices, the
income that investors receive will rise in line with inflation; so they should
be left no worse off – unless, of course, the bond issuer fails to keep up with
repayments (an unavoidable risk for bond investors). If prices fall, however,
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so would the value of inflation- linked bonds and the income from them
– in contrast to bonds whose principal and coupons are fixed and which
would therefore be worth more in real terms. If inflation falls, protection
from it rising can therefore come at a price.
PROTECTION DURING INFLATIONARY PERIODS
To beat rising prices, the total returns from any investment – being the
combination of capital growth and any income – must be greater than the
rate of inflation. As a result, company earnings may have the potential
to keep up with inflation, all things being constant, but there can be
no guarantee of this – some companies may fail in inflationary times.
However, company shares (or ‘equities’) do potentially offer long-term
investors a degree of protection during inflationary periods. Ultimately,
shares are claims to the ownership of real assets, such as land or factories,
which should appreciate in value if overall prices increase.
INCOME STREAM AS WELL AS CAPITAL GROWTH
Equity returns, in theory, should therefore be inflation-neutral, so long
as companies can pass on any higher costs they face and maintain their
profitability. In turn, a company’s ability to make money will typically
be reflected in its share price and its ability to provide investors with an
income in the form of a dividend. Opting for a fund which invests in a
wide spread of companies is less risky than putting your money into just a
handful of shares.
HIGHER INFLATION SQUEEZES PURCHASING POWER
These vehicles invest in the shares of dividend-paying firms or companies
that tend to share their profits with their shareholders, and investors can
opt to either take the income or instead re-invest it. It is vital to understand
that dividends are not guaranteed: they depend on companies’ profits, and
those companies can decide to cut or cancel their payouts altogether – all
of which can also cause share prices to fall.
STAYING AHEAD OF INFLATION
Inflation has been quiet for a very long time. But there are some signs that
inflation may be about to return. If it does, are you prepared? It’s essential
to ensure your portfolio includes some areas that may benefit from or be
resilient to interest rate rises.
If you would like to discuss your investments or if you have any
questions, please contact us on 0151 236 9973.