The Bank of England recently revealed predictions that consumer price inflation (as measured by CPI), could exceed 10% year-on-year.
This has come as a shock to a British investor community that has grown acclimatised to:
- Low price inflation
- Low-interest rates
- Low discount rates (rate of return for risk)
Each of these factors fuelled a bull market for equities that ran from 2009 to 2019 (prior to the global pandemic).
The question of how investors should respond to this macro-economic shift is the subject of this article.
- Reset your level of basic financial need
- Don’t deny reality – consider reducing your saving rate
- Ensure your asset allocation can beat inflation
- Hold as little cash as you can
- Reset your level of basic need
When the price of goods and services increases, the cost of our financial goals will likely rise in step.
The price of that wedding or university education you’re saving for? It most likely rose by 10% over the last year. Therefore it’s time to revisit your fundamental savings goals and raise them accordingly.
In a high-inflation environment, it’s also worth anticipating future price inflation in your financial goals. If your savings goal is several years away, you should incorporate an assumed inflation rate between now and then rather than basing your goal upon a price level that will be outdated by the time you reach your destination.
- Don’t deny reality
Regular investing habits are usually ingrained in a monthly direct debit that moves cash from a current account to a stockbroker account. Therefore it’s very easy to maintain the status quo in any short-term period. Do nothing, and those regular transfers will continue.
However, if their affordability has now taken a nose dive then this transfer will begin to deplete your current account and could put your emergency fund at risk.
If you originally decided upon your monthly direct debit by starting with your take-home pay, deducting your outgoings and leaving a cash buffer, it’s likely that buffer has been eroded.
The importance of a rainy-day pot of cash savings is as important as ever, so do take this opportunity to shrink your monthly investment commitments if you need to.
- Ensure your asset classes are inflation-proof
Asset classes are the types of investments you hold. They are separately identifiable because of their different characteristics. For example, cash, equities, bonds, real estate and commodities.
One characteristic that now holds the spotlight is the proven ability of each asset class to keep pace with inflation (or even exceed inflation).
The writers at Financial Expert explain that many asset classes have a reputation for being a hedge against inflation that is perhaps undeserved. Notably, cryptocurrencies and gold have a poor track record when you analyse the data rather than rely upon anecdotes. These assets may occasionally rise during a period of inflation, giving rise to headlines that reinforce their apparent inflation hedge qualities. But over the longer term, they have been poor investments across multi-year periods.
Only equities and real estate have reliably out-paced inflation over the long term.
- Hold as little cash as you can
It almost goes without saying that cash is a risk asset in today’s high-inflation economic environment. With a 9.1% inflation rate, cash held over the last 12 months has lost 9.1% of its spending power. This may not look like a loss on paper, (after all, your bank account is still the same value) but in real terms, this cash can now buy less than it could a year ago.
With a seemingly ‘safe’ asset losing almost 10% of its value within just one year, even cautious savers are beginning to wake up to the notion that cash isn’t the risk-free asset they thought it was.
Cash will always serve an important purpose: giving us a short-term guarantee that we can cover bills and make crucial purchases. But we should shift our mindset to think of a bank account as a potential liability during high inflationary periods.
