Get ready for the vicious hidden tax we haven’t seen in more than a generation
There are places for investors to hide, but now is the time to make plans
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The market’s recent correction has been blamed on three factors. Investors can’t do much about two of them. First, high valuations after a long and strong bull market mean returns will probably be lower from here. The odds of a happy outcome are simply reduced by the higher starting point.
Second, the rise of the robots is beyond our control. If automated program trading means markets over-react more, we will just have to live with those gyrations.
The third cause, however, can be managed. Any meaningful return of inflation will have predictable and time-tested influences on our investments. The time to prepare for a more inflationary environment is now — before rising prices become entrenched.
It was no coincidence that the market correction began two weeks ago, immediately following the publication of stronger-than-expected employment data and the first tangible evidence of rising wage inflation. Rising household earnings have been the missing piece of the inflationary jigsaw, so faster wage growth was the trigger for a reassessment of the outlook for interest rates and bond yields.
Rising rates and yields are bad news for stock market investors for two reasons: they reduce companies’ profits by increasing their borrowing costs; and they make safer fixed-income investments relatively more attractive, encouraging a rotation out of shares. Not for a generation has inflation hit double digits anywhere in the developed world and investors have largely forgotten what it means. It is time to reacquaint ourselves with its malign influence.
Inflation is a vicious hidden tax. Even a relatively modest inflation rate can devastate your purchasing power over time. It’s easy to work it out. Divide the expected inflation rate into 72 and the answer will be the number of years it will take to halve the real value of your money. To take an extreme example, a 12 per cent inflation rate achieves this in just six years. If prices rise by 3 per cent a year, you will lose half your spending power in 24 years.
The next thing to understand about inflation is that it is a drag on both stocks and bonds. Since the Thirties, U.S. shares have delivered real total returns of about 14 per cent in periods of falling inflation, but pretty much zero when it has been rising. The 10-year Treasury bond has given 4 per cent real returns when inflation has been in decline and a small negative return on average when it has been increasing.
Another factor that makes life more difficult for investors when the inflationary tide turns is the fact that bonds and shares start to behave much more like each other. When growth is low, bonds can provide a useful counterpoint to weak equity performance. In a rising inflation environment, however, bonds behave much more like shares and investors have to work harder to generate a smoother ride for their investments. Fortunately, there are some asset classes which perform better as prices rise.
Commodities tend to respond well if higher inflation is a reflection of rising demand. If the US tax cuts pour fuel on an already smouldering fire, as I fear they might, the cost of natural resources is likely to increase.
In the early stages of an uptick in commodity prices, the share prices of commodity producers are often the best way to play this theme because companies can benefit from a lag between the rise in the price of their products and an increase in their cost base. Of all commodities, gold has been seen as the best store of value relative to paper currencies which lose their value when inflation rises. The case for gold is only partially undermined by the fact that, with no income, the opportunity cost of holding it is greater as interest rates and bond yields rise.
Other assets to consider in the search for diversification include short-term bonds. These are less impacted by inflation because investors can roll them over frequently before rising prices have had a chance to erode their value. A 30-year bond, by contrast, will see its value decimated in an inflationary environment.
Property is worth a look too because it is a physical asset in limited supply. It generates a rent which rises in line with inflation. Inflation-linked bonds benefit from having their income and capital value adjusted in line with prices. Some loans to companies can also offer a variable income as short-term interest rates fluctuate, although there are obvious risks.
So, there are places to hide if you are worried about the return of inflation. It’s worth bearing in mind that these kinds of assets will tend to under-perform if price rises remain subdued so you would need to assume a real Armageddon scenario before putting more than a small proportion of your overall investments into them. The final considerations are your age and personal circumstances. This is because inflation does not affect everyone in the same way. A retired investor, living on a fixed income stream from a conservative portfolio with more bonds than shares, will feel the inflationary squeeze more than a young investor with a rising income and a portfolio weighted towards equities.
There is plenty that, as investors, we have no control over, but some things we can sensibly respond to. Inflation is one of them.
Tom Stevenson is an investment director at Fidelity International. The views expressed are his own.
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