Inflation: What is it? What should you do?

Fri 27 Jan 2017

By Brian Dennehy

Access Level | public

Market commentary


researchYou need to understand the nature of this problem – there is much hype and misinformation written on this subject. And to the extent there is a problem we need to explore what you can do about it. 

Your problem is that inflation effectively reduces the value of your investments. The more inflation there is the higher the rate of growth needed to overcome its negative effects.  

Similarly, if you are generating income from your investments, which is one key reason why we try to focus on funds with the ability to grow their income payouts. 

What triggered the forest of inflation headlines? 

After the surprising Brexit vote sterling fell sharply. Among other things this will push up the cost of imported goods, raising prices for consumers, hence the phalanx of worrying headlines. 

What is inflation anyway? 

Inflation can come in many forms. It isn’t simply about prices going up, and in one key instance it isn’t about prices at all. 

First, from an investors perspective it’s important to distinguish between “good” inflation and “bad” inflation. 

In a good inflationary environment, inflation goes hand-in-hand with rising productivity, rising wages, greater business investment, higher economic growth and higher interest rates. In a “bad” inflationary environment prices go up but people hold off spending, resulting in an economic slowdown. 

Secondly, some inflation is inherently temporary in nature, and other types are embedded and of greater concern to policymakers. For example, if inflation is going up because the currency has fallen (rising the price of imports such as food), this will usually be temporary in nature. In fact, it can be DEflationary, because higher food prices will slow spending on other products or services, dampening economic growth. 

In contrast, policymakers will be worried if “good inflation” morphs into over-confidence, over-spending and speculation, typically fuelled by too much borrowing. At this point ideally interest rates will rise sharply, to take away the punch bowl before the inflation party goes OTT. 

Yet another type of inflation might be asset price inflation. This could be runaway house prices or stock markets. 

In this case, we should also expect authorities to act early, though, ideally, not by raising interest rates and hurting the wider economy. We saw this in recent years with buy to let properties – rather than interest rates being put up, regulations increased, taxes went up, and lending became more restrictive. 

Big trends and inflation shocks 

There are two big trends which will put downward pressure on inflation for years to come: ageing populations and massive amounts of debt in the developed world (and China). 

As we’ve said many times: older people aren’t high spending consumers, and debt interest payments suck the air out of an economy. The evidence on both points is very clear and politicians have no power over either – though they can take mitigating action. 

In parallel with these big trends we should not overlook the march of new technology, keeping both prices and wages low. 

At the other end of the scale, an inflation shock is a possibility, but by its nature the timing cannot be anticipated. The best historic example is the quadrupling of the oil price in the 1970s – Brexit and falling sterling are simply not on that scale. Many, including ourselves, have been anticipating sterling weakness for a number of years - so there is no shock. 

Should you be worried? 

As an investor, the evidence for good inflation is limited, and while rising import prices suggests bad inflation, it should be of a temporary nature. So, it would be daft to increase interest rates and make any economic slowdown even worse. 

It feels more like we are in a bit of an inflation no-man’s land. Nothing to panic about in the short term, but stay wary. 

Nonetheless, taking a longer view (for example through a long retirement), even low inflation can hit hard.  For example, even with 3% inflation the value of your income halves over 20 years, and drops by 40% over 10 years if inflation is 5%. 

So, it is still sensible to have investments which tend to provide inflation protection 

Inflation protection – what doesn’t work? 

Bonds – These range from gilt-edged government bonds to corporate bonds and high yield. There are a range of yields, but no growth in the income that bonds throw off. 

Property – Commercial property funds are poor as a long-term provider of capital growth and growing income. Houses have been a decent inflation play, but of limited value when you live in it. And the debt-fuelled buy-to-let market is being deliberately deflated by Government action. 

Gold – There may yet be some value left in gold mining stocks over the short term but this is not a long-term solution to inflation - ignore those who say it is. 

Inflation protection – what DOES work? 

In the long term the stock market as a whole provides decent inflation protection. 

For example, over the last 116 years the stock market has provided a return 5% per annum greater than inflation. (Source: Barclays Equity Gilt Study 2016). 

Best stock market options? 

If the stock market is the best long term inflation-beater, we want to identify investment approaches which tend to perform better than the stock market indices. Over longer periods a range of quality research has illustrated that there are four investment approaches which tend to outperform the stock market indices (even if they might underperform over shorter periods): 

  1. Value Investing. Buying what is unjustifiably cheap (Schroder Recovery, M&G Recovery
  2. High Yield Investing. Buying shares with above average dividends, and reinvesting these (JOHCM UK Equity Income
  3. Small Cap Investing. Buying the shares of smaller companies 
  4. Momentum Investing. Buying winners, the top performing shares (or funds!) of the last 6-12 months. 

Value Investing looks particularly attractive now. Ditto Small Cap Investing

And with much of the world’s (ageing) population desperate for income for a decade or two to come, High Yield Investing should also benefit from growing demand for a decent income. 

In conclusion, there are some great buying opportunities now for investments which should provide growth handsomely higher than inflation in the long run (and in the short run too, with a little luck).


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