Beating inflation just got harder
Chris Brown, CIO, 4th November 2016
Events this week have shown us that we still don’t know what Brexit will eventually look like or even how long it will take to implement. Speculating on the impact (good or bad) of Brexit therefore looks to us like a fool’s errand. There are, however, two things we know for sure today: inflation will rise in the UK (as a result of sterling’s post-Brexit collapse) and cash returns will be lower (as a result of the Bank of England’s easy money policies). This means that the gap between cash returns and expected future inflation is wider than it has ever been for at least the last 50 years.
We illustrate this in Chart 1. This shows the market expected inflation rate and cash returns over the next five years and compares them to how the picture looked 20 years ago. You can see that back in the heady days of the 1990s you could sit in cash and expect to make a return of inflation +3.5% per annum over the next 5 years. Today the equivalent return is inflation minus 2.5%. Cumulatively in 1996 you would expect to be ahead of inflation by 19% at the end of the 5 years if you just sat in cash. Today you should expect to be 12% behind. That’s over a 30% swing. The bad news therefore is that sitting in cash will have a significant cost in real terms as you should expect the purchasing power of your money to be slowly eroded by inflation.
In fact, all inflation linked return objectives probably need a review. As an example, according to Barclays’ latest long run returns study (Barclays Equity Gilt Study 2015 – see Figure 1) equities have generated an average annualised return of cash +4.2% since 1900. 5 year gilts currently yield around 0.5%. Assume that we actually make the long run return of cash +4.2% over the next 5 years. This gives us an expected total return of 4.7%. The problem comes from the fact that the market’s expected average inflation rate for the next 5 years is 3.1%. This means there is a reasonable (if conservative) case to be made that expected equity returns for UK investors are only equal to inflation +1% to 2% pa.
What can we do about this? At one level the answer is not much. The immediate consequence of Brexit is that interest rates were cut sharply to deal with the expected economic impact and sterling fell sharply. This lowered future cash returns and raised expected inflation. However, within the new post-Brexit reality we still think there are some attractive opportunities for clients. We list below three areas that remain front and centre of our priorities:
- First we have been allocating and will continue to allocate to infrastructure assets. These offer yields of circa 6% to 8% that are linked to inflation either directly (via an inflation linked government subsidy) or indirectly (via energy prices which you would expect to rise in line with inflation over longer periods of time). These assets meet the inflation plus targets of our clients today and there is a good chance they will continue to do so.
- Secondly, we continue to have the majority of our investments in “real” assets that should have some inflation protection built into them. The value of our equity investments, property and the infrastructure assets we discuss above should broadly rise in line with inflation, all other things being equal. This means we should have some post-Brexit inflation protection naturally built into the portfolios.
- Finally, we are committed to remaining as multi-asset and diversified as possible. Looking for as many different investments and sources of return for clients remains the key way we can protect against all the surprises that markets, central banks and politicians regularly throw at us. As an example, simple equity and bond portfolios remain very vulnerable to rising interest rates triggering falling equity prices. Whilst we cannot prevent this scenario happening we can limit the impact of this by allocating to other assets (including absolute return funds) that do not face this risk directly.
The more uncertain the world looks the more we are convinced this is the right way to manage money for our clients.