Following months of warnings, rumour and speculation, investors are keeping an eye out for signs of higher inflation.
As recently as late June, the Bank of England sought to ease inflationary fears after data showed prices rising faster than expected as the economy rebounded more strongly than forecast.
Is a spike in inflation a cause for concern?
For long-term investors in funds that can adapt to changing market conditions by actively investing across multiple asset classes, the answer is no.
When looking at a client’s investments, their ability to accept a higher level of uncertainty in exchange for the possibility of greater returns, depends on three factors.
Firstly, there are the risks embedded in the client’s individual circumstances – for example, a freelancer whose income is uneven.
Second are the circumstances that are impossible to foresee – for example, having triplets, or discovering a pre-Raphaelite masterpiece in their loft.
Third is how the client reacts to uncertainty – some people abide uncertainty better than others.
We can simplify clients’ investments by dividing them into two camps: nominal assets, whose value is linked to a notional debenture to be honoured (like cash and most bonds), and real assets, whose value is linked to the ownership of underlying assets (like property, commodities and, for the most part, equities).
Importantly for investors, each responds very differently to inflation.
Inflation, or a sustained increase in prices, is a vital consideration when saving for the future. This is because its effects over time are considerable.
Consider this scenario: In January 1971, you are given a bond that pays 10p per day for the rest of your life. At the time, an 800g loaf of bread sold for 10p, so you could be forgiven for thinking your bread expenses are covered for the foreseeable future. However, by January 2021, the same loaf costs 106p. Now your bond does not cover a tenth of the price. This is the power of inflation.
In the long term, it would have been better to receive a basket of stocks back in 1971, rather than the bond.
Though the value of the stocks – and their dividend payments – would have fluctuated in the intervening 50 years, their values correspond more closely with the inflation-adjusted cost of life.
This is because the companies behind equities produce the goods and services people pay for, and these prices are what compose inflation.
Inflation normally occurs for two reasons.
One is scarcity: in times of economic booms, companies can struggle to find workers and resources to cope with demand, wind up paying more to obtain them, and then raise prices to meet these increased costs.
The second is currency debasement – when governments print more money, the value of the money its citizens have been saving falls.
Here, in one of our favourite graphics, you can see how the silver content of a Roman denarius fell as the rulers of the Empire debased the coins to fund expansion. Evidently, a denarius bought far less in AD268 than it did in AD64…
Source: Tulane University, Société Générale
Whereas modern methods of injecting money into an economy – such as quantitative easing – have more nuance than those used by the Romans, they too can lead to inflation if the increase in monetary mass finds its way into the economy.
When considering ultra long terms, it pays to consider riskier asset classes, if the expected long-term return is appropriate to the risk taken. This is because the effects of compounding at a higher rate will help to meet the higher costs of living brought on by inflation.
Sticking to low-risk, low-return assets – such as fixed income – is unlikely to be sufficient to meet those future expenses.
There are of course three important footnotes to this, which underline the importance of advisers regularly reviewing their clients’ needs.
Firstly, some clients receive an income that is less predictable, so may be attracted to asset classes with more predictable short-term returns.
Secondly, as clients approach retirement, they may have both short- and long-term liabilities, and their asset mix should reflect that.
Finally, people may prefer less volatile asset combinations because of their financial personality.
Then there are the benefits of diversification.
Mixing assets has the advantage of reducing risk to a greater degree than its reduction in return. This is because asset classes are not perfectly correlated and react differently to various market conditions. By not sitting exclusively in one or the other asset class, investors can smooth their return stream and receive a diversification benefit.
Saving is an asset-liability puzzle. A client’s portfolio should reflect life’s uncertainties and how able they are to endure certain levels of risk.
Investments based on real assets (equities, commodities) tend to be more volatile in the long term than those based on nominal assets (cash, government bonds), but also provide a better hedge against inflation.
Education is essential: clients should be aware that (i) the future will arrive, (ii) they will need to fund it, and (iii) putting money in low-risk assets may not achieve that objective.
Finally, diversification is a powerful tool to reduce expected risk in a way where less expected return is sacrificed in the trade-off, improving the expected remuneration per unit of risk.
About the author
Thomas Rostron, Chief Executive Officer, Horizon by Embark
Thomas is the CEO of Horizon by Embark, following Embark Group’s acquisition of Zurich’s Authorised Corporate Director (ACD) & Investment Management (Zurich Investment Services (UK) Limited) businesses on 1 May 2020. Thomas has more than 30 years’ experience in asset and wealth management, including positions as Head of Global Fund Distribution at Fortis Investments and Managing Director Investment Management with Barclays Wealth.
Past performance is not a guide to future performance. The value of investments can go down as well as up, so your client could get back less than they invested. The value of funds can fall and rise purely as a result of exchange rate fluctuations. Investments in newer markets, smaller companies or single sectors offer the possibility of higher returns but may also involve a higher degree of risk.
Horizon by Embark is a trading name of Embark Investments Limited, a company incorporated in England and Wales (company number 03383730). Embark Investments Limited is authorised and regulated by the Financial Conduct Authority (Financial Services Register number 628981). Registered Office: 100 Cannon Street, London, EC4N 6EU.
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