What effect does inflation have on investments?

Fairytale ending on hold as inflation rises

Let’s face it, nobody likes it when prices go up.  Over the last few months, prices have risen at the petrol pumps and the cost of our weekly shopping has increased too. Combine these with the energy price cap and subsequent price increase has led to much discussion on increased inflation.  But what is inflation and how does it impact on your assets, such as cash deposits, ISAs, and pensions?

The increase in goods and services mentioned above is one way that inflation impacts us.  To the economist, inflation is a persistent rise in the general level of prices in an economy over a particular period of time.

Why is it important?

Well, if inflation is running too high, the economy may be overheating and conversely, if inflation is very low (and prices are falling) then this may indicate that the economy is heading for recession.  Therefore, inflation is important as it acts as the ‘canary in the coal mine’ for how well an economy is performing.  The ideal scenario is that inflation runs neither too hot, nor too cold, which is often referred to the ‘Goldilocks economy’ and why the Bank of England has an inflation target.

So inflation is important to economists and policy makers alike, as increased inflation leads to a decline in purchasing power of the money in people’s pocket.

How is inflation measured?

It follows that for inflation to be monitored, it must be measured.  Inflation in the UK is measured using a number if indices.  Most of us will be familiar with the Retail Prices Index (RPI) and the Consumer Prices Index (CPI).   Historically RPI was the favoured index however since 2003, CPI is the preferred measure.  The main difference between the two is that RPI includes the cost of housing (mortgages, council tax etc) whereas CPI does not.  This difference led to RPI running much hotter than CPI.

CPI is measured using a basket of some 700 plus goods and services that government statisticians feel represent how a typical household spends its money.  This basket is reviewed and is updated as consumer behaviour changes. For instance, in 1947 the basket included wild rabbit and household mangles whereas the latest basket includes meat-free sausages, canned pulses and antibacterial surface wipes.  Dropping out of the latest basket were men’s suits, doughnuts, and coal.

All this data is collated and used to estimate how prices have risen over the last year.

What causes inflation?

Inflation occurs as businesses raise their prices based on the level of demand in the economy. There are various factors in play which push and pull inflation demands and expectations, which requires a whole new article!

What does it mean for my investments?

Inflation is bad news for cash savers, where persistent increases in prices erodes the real purchasing power of their savings.

For those invested in the stock market either directly or through their ISA and pensions, the companies they ultimately invest in may well outperform inflation, but this is of course not a certainty.  Those companies that can pass on the rising costs to their customers should weather the storm better than those who are unable to do so.

What are the best assets to invest in?

Inflation-linked bonds offer a rate of interest linked to the rate of inflation. As inflation rises so does the value of the bond’s value and interest payments.  Property can be useful too, especially where rental income is linked to inflation.  As inflation rises, investors often rush to gold which has historically been seen as a haven in times of uncertainty.

The bottom line

With inflation recorded at 7% in March 2022, investors may be tempted to rotate into inflation busting strategies.  However, many commentators feel that this inflation is a temporary spike due to post pandemic supply and demand issues, and the dreadful events in the Ukraine.  As with all investments, there are no guarantees and holding a well-diversified portfolio for the longer term is preferable to making large inflation pressured investment calls with your money. For those looking for financial planning help, ensure that your advisor is suitably qualified and experienced.

If you looking to make an investment, contact our Wealth Management team on info@thomsoncooper.com to make an appointment.

Richard Libberton

Chartered Financial Planner

Richard is part of the Thomson Cooper Wealth Management Team and Chair of the Personal Finance Society Central Scotland Region.

 

The information contained within this article is for information only purposes and does not constitute financial advice or recommendations. Thomson Cooper cannot assume legal liability for any errors or omissions it might contain. The value of investments can go down as well as up and you may not get back the full amount you invested. The past is not a guide to future performance and past performance may not necessarily be repeated.