Inflation

Many investors today have no experience of dealing with serious inflation. However, those who had mortgages and loans in the 1980s certainly remember the pressure of double-digit interest rates and Irish inflation running close to 20%. Globalisation, demographics, and other factors have pushed inflation rates lower over the past forty years (see chart below). It may be worth considering whether that multi-year downtrend could be impacted by Covid-19 economic policies and think about what that could mean for investment markets.

 

Chart 1: Irish Inflation 1960 – 2020

World Bank, Inflation, consumer prices for Ireland [FPCPITOTLZGIRL], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/FPCPITOTLZGIRL, August 5, 2020.

Government Money Printing and Inflation

The Global Financial Crisis of 2008/09 triggered a strong response from Global Central Banks with large interest rate cuts and enormous amounts of unconventional monetary policy. Many commentators at the time predicted that consumer price inflation would rise as a result, but it did not. One explanation may be that the money created in the process did not make its way beyond the banking system.

Different this time?

Covid-19 caused a new Global Financial Crisis and once again a strong response from global Central Banks. However, the response in 2020 vs. 2008/09 has been much larger and much quicker. Interest rates were cut aggressively in March along with the introduction of huge economic stimulus packages in response to heavy stockmarket declines.

In addition to the speed and magnitude of the response, what’s different this time is (1) Money has been sent directly to individuals & small business and (2) Governments have provided large bank credit guarantees. Unlike 2008/09, money is making its way beyond the banking system. The big question now is whether this will be inflationary.

 

Why does inflation matter to you?

Inflation can be defined as a general increase in prices and fall in the purchasing value of money, so in short it matters to everybody.

 

Let’s take an example of a 45-year-old with €100,000 cash in the bank. We shall ignore the fact that some bank interest rates have moved below zero and assume a 0.05% interest rate.

What impact does inflation have on that cash in the bank?

Chart 2 below shows the projected yearly value of that initial €100k in ‘real-money’ terms, i.e. adjusted for inflation to represent the future purchasing power of that money in today’s terms.

Over a 20 year period from age 45 to expected retirement at age 65, the ‘real money’ value falls to €67,772 with an inflation rate of 2%.

Chart 2: Illustration with 2% CPI Inflation

In Chart 3 below we use a 4% projected inflation rate (not out of the ordinary in historical terms when you refer to chart 1 above) the ‘real money’ value falls to €45,961 over the same period – A decline of more than half –

Chart 3: Illustration with 4% CPI Inflation

What assets might one hold in times of inflation?

Long term investors know that the best generator of investment wealth is typically the equity market. In his book ‘Stocks for the Long Run’ Jeremy Siegel showed that US stocks delivered an 8.1% annualised nominal return for the 210 years from 1802-2012 (6.6% real annual return after inflation). This is close to a doubling in purchasing power every decade for two centuries.

Equities may not be a ‘perfect’ inflation hedge, but they generally do a decent job. Property can also perform in times of inflation (but worth keeping in mind that rent controls may impact negatively).

Some other assets considered to provide inflation hedging characteristics are:

Commodities – not convenient for small investors to buy.
Gold – Already performing strongly in 2020
Inflation Linked Bonds – Government bonds designed to keep pace with inflation

What assets typically underperform in times of inflation

There are two big ones here. Firstly, cash as seen above always loses in real terms and particularly so in times of high inflation. Keeping cash on hand in rainy day funds and for short term expenses is always sensible, but generally not for longer term purposes such as providing retirement income.

The second asset class that typically performs poorly in times of high inflation is long-term nominal bonds. Bonds can perform an important role in investment portfolios, reducing volatility, providing liquidity and helping achieve the correct mix of growth and defensive assets for each individual’s particular needs. However, within the bond component of each portfolio, care should be taken to understand the mix of short-term vs long-term bonds and whether there is an allocation to inflation-linked bonds.

Suggestions for individual investors

All successful investing is goal-focused and planning driven. With that in mind, the core elements of financial planning remain the same as always and we suggest the following:

• Define the financial goals & objectives for you and your family.
• Re-run your risk tolerance analysis if you’ve not done so recently.
• Consider your investment asset allocation and whether it remains appropriate.
• Beyond your ‘rainy-day’ fund, decide how much cash you need to hold.
• Run your annual lifetime cashflow analysis with a range of different inflation assumptions.

 

Wishing you an enjoyable summer break, and I would welcome your connection on Twitter, Linkedin or Facebook.