Is inflation back? Don’t panic – How to protect the value of your money from its effects

25 Jul 2018

Is inflation back? Don’t panic – How to protect the value of your money from its effects

Is inflation back? After two years when consumer prices in the UK barely rose, the annual rate of inflation has risen above the Bank of England’s (BOE) target of 2% in 2017. The combination of high inflation and limited wage growth – as well as uncertainty about the terms on which Britain will leave the European Union in 2019 – is expected to mean Britain’s economy grows more weakly than other EU economies this year.

The BOE 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.

To protect your purchasing power over time, your savings need to grow at least as quickly as prices are rising. So how can savers and investors protect the value of their money from its effects?

Cash is not king

The positive for cash savings is that they are very secure up to £85,000 in a bank or building society through the Financial Services Compensation Scheme, unlike other investments where your capital will be less secure. And keeping enough cash aside to cover any foreseeable costs you might face is always sensible.

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. And 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.

Inflation-linked protection

Bondholders receive regular income payments, known as ‘coupons’, from the Government or company that issued the bond. Where coupons are fixed in value for the life of the bond – often several years – the real value of this income will be eroded if prices rise. The nominal value of the bond (known as the ‘principal’) will also be worth less when it matures and the loan is repaid.

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).

However, if prices fall, so would the value of inflation-linked bonds and the income from them – in contrast to bonds, whose principal and coupons are fixed, and so would then be worth more in real terms. If inflation falls, protection from it rising can therefore come at a price.

Combining equity returns

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. Company shares, or equities, 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.

In theory, equity returns 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. Also, the sum of a company’s shares can be much greater than the value of its physical assets.

Where higher inflation squeezes consumers’ purchasing power, however, some companies may find it difficult to pass on higher costs, reducing profitability and, probably, investment returns. Just as a company can raise its dividend in line with inflation, it can choose to cut or stop the payout at any point.

Take an active investment approach

Selecting the right combination of investments to navigate rising inflation could be challenging for many individual investors. By investing through a fund that pools your money with other investors, you can gain access to expertise as well as a wider range of investments.

Professionally managed ‘active’ funds will aim to achieve a specific objective by investing in certain assets, with an approach to risk and return that may align with yours. The objective of an actively managed fund could resonate with your own goals – something that ‘passive’ funds, which look to mirror the performance of a broad index, may not be able to do.

Active fund managers can take inflation into account in pursuit of their objective, which could be providing their investors with a growing income stream or achieving capital growth over the long term.

Some funds even specifically aim to deliver total returns in line with, or greater than, a given measure of inflation – for example, consumer prices in the UK. Unlike those who passively invest, active managers can handpick assets they think are less likely to suffer, or more likely to gain, from any change in the rate of inflation.

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