The start of a new year is a time to stop, take stock and set yourself new goals. And since as a nation we have squirrelled away more money than we have been able to in years, it might also be time to rethink your savings strategy and have a go at beating inflation.
UK inflation currently stands at 5.1% – more than double the Bank of England’s 2% target rate – and BoE Governor Andrew Bailey has recently gone on record as saying that he feels “very uneasy” about it.
Although there are still hopes that this steep rise may only be temporary, inflation is universally recognised as the “silent thief” that erodes the purchasing power of your cash reserves, decimating your finances.
“Inflation is what poses the greatest risk to your capital”, says Investment Quorum’s Director of Private Clients Nick Rolf.
After a decade of record low interest rates, trying to beat inflation with a high street bank account is an exercise in futility. “You are currently looking at between zero and half a percent on an easy-access savings account, possibly up to 1.8% if you are willing to tie up your money for at least three years, but that is way below inflation”, says Nick. “You’ve got real value depreciation in your cash. Sure – keep enough to finance your way through one to two years of necessary expenditure, but as an investor, your primary objective is to beat inflation. If you don’t, then ultimately, you are going backwards in terms of the real value of your portfolio”.
Peter Lowman’s job as CIO at Investment Quorum is to construct sensible risk-adjusted client portfolios that deliver acceptable investment returns – against any economic backdrop.
“In periods of rising inflation, as we are currently seeing, coupled with very low interest rates, asset classes such as cash and sovereign bonds are very unattractive. So you should only allocate minimum cash amounts to them”.
Indeed, if you look at sovereign 10-year bench-mark bond yields, such as US Treasuries, UK Gilts, German bunds or Japanese bonds, their current yields guarantee a global investor a negative return. Similarly, for a UK investor buying overseas bonds, there is the added risk of currency loss – unless they are hedged.
There is potential for both capital and income returns in some of the bond classifications, but in this inflationary environment, your best bet is to invest your money through a strategic bond fund where an experienced bond fund manager can make the right asset allocation calls on your behalf.
“Inflation is taxation without legislation”, as Milton Friedman famously observed. And it destroys your savings if you don’t take the right action.
Index-linked bonds issued by governments are worth considering, along with floating-rate notes where the asset class tends to increase in line with inflation, thus providing some level of protection.
The slight problem at the moment is that the current inflationary environment has increased demand for this asset class, making it less attractive. Furthermore, after 12 years of soaring bond prices catalysed by central bank monetary policies and aggressive bond buying-programmes, there is now a risk that as monthly bond-buying is reduced and interest rates creep up, we might see another “taper tantrum”, such as the one we experienced in 2013.
Our mission at IQ is to help clients beat rising inflation. Needless to say, that does involve taking on a measure of investment risk – and we know that not every client is comfortable with that. But there is no denying that great businesses (quality equities) have delivered fantastic returns, outpacing inflation.
Indeed, investment returns over the past 12 months or so have been more than inflation-beating. Wall Street in particular has constantly seen its indices hit new all-time highs, with the technology sector achieving its best year ever.
Peter applies a “tech and toothpaste” (innovation and consumer stocks) strategy in times of higher inflation or market crisis: innovative companies continue to disrupt the market, increasing their market share and their corporate profitability, enhancing investor returns in the process.
Businesses with pricing power will maintain their margins during challenging investment cycles. And such businesses tend to be in consumer staples, communication services and of course IT.
If a company such as Colgate decides to increase the price of a tube of toothpaste by 20 pence, most people will decide that – on balance – they are keen to hold onto their teeth and will pay it. That’s pricing power. Consumer staple companies tend to hold their value during periods of inflation – it takes a lot to impact their sales.
A household is highly likely to cut back on certain types of spending – holidays and theatre outings, for example –, but they are not so likely to switch their favourite brand of washing powder or cut down on soap. Companies like that can pass on the cost of rising commodity prices to the consumer and they will simply suck it up.
“But we might be more reluctant to pay an extra twenty quid for a new dress or shirt when money is short”, says Peter. “So those companies are less likely to fare pretty well during periods of rising inflation”.
Although globally a great deal of uncertainty remains in relation to Omicron, many companies are nevertheless recovering from nearly two challenging years, and a portfolio of quality stocks is a good bet for beating inflation.
Furthermore, the UK market can offer good value at the moment: the FTSE 100 Index, for example, is offering investors a yield of around 3.8% – higher than its historical average. With the potential for an attractive capital return generated by some of the previously “unloved stocks”, this is another way for investors to outrun inflation.
We have also seen the emergence of a number of “pandemic friendly” companies over the past couple of years – these are all-weather companies that tend to perform well during periods of higher inflation. They include the “stay-at-home” companies with which we have become familiar (Amazon, Netflix, Apple and Ocado), as well as companies in the energy and banking sectors that are positively correlated to inflation and higher interest rates, and will thrive in our fast-changing world. Furthermore, recent supply bottlenecks have caused the share prices of oil and mining stocks to soar in 2021. And of course the global shortage in the supply of semiconductors has pushed up chip prices.
Another sector that is investor-friendly during periods of inflation is infrastructure. Even as we strive for net zero, there is continuing demand for new roads, new clean power supplies and ever more sophisticated telecommunications networks. The companies that operate in these sectors tend to enter into long-term contracts which have inflation protection built into them.
Although factoring in broad economic trends is doubtless important, when it comes to beating inflation, the real key for investors really is very simple: stay invested in quality businesses.
Peter says: “We say this week in, week out, but that’s because it’s true: having a well-diversified portfolio that you are happy to own over a considerable time horizon is the best strategy. That way, you can sit back, stop worrying about inflation and tune out all the market noise”.
So cranking up the risk factor a few gears by moving into equities and rebalancing your investment portfolio is a good way to lessen the impact that inflation might have on your wealth. Investment Quorum can also help you make sure that you are not giving any more away to the taxman than is strictly necessary.
Nick Rolf says: “From a tax perspective, the playing field is far from level. If you want to avoid CGT, stamp duty, agency fees and all the taxes associated with various other asset classes, that does not leave much left to buy– apart from equities”. And obviously leveraging all the benefits of tax shelters is a good way to protect your investment returns – and mitigate the impact of inflation.
We still don’t know how long this current spike in inflation will last. But our in-house advice remains unchanged: opt for productive assets, such as high-quality businesses with low capital needs and stay away from low-yielding bonds – their payments will not increase as inflation rises. Oh – and did we mention staying invested?