Why Investors Should Be Wary of Inflation

How does inflation erode investment returns? What can investors expect from inflation? And how can you invest to beat inflation?

Emma Wall 3 May, 2017 | 1:56PM
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Emma Wall: Hello, and welcome to the Morningstar series, "Why Should I Invest With You?" I'm Emma Wall and I'm joined today by James Klempster, Head of Investment Management for Momentum.

Hello, James.

James Klempster: Hi.

Wall: So, we're here today to talk about inflation, a hot topic with investors. They've kind of been able to ignore it over the last couple of years, but it has certainly come to the fore. At the moment, we're looking at 2.3% inflation in the U.K. Do you think that level will be sustained?

Klempster: I think it's interesting that as you say inflation has become topical. We've been talking about it for a long time because we believe it's a key consideration for the long-term for investors. But it has been very much in the background. Since sterling weakened post-Brexit we got a lot of cost-pushed inflation which is where imports largely have started to raise their prices in sterling and that's been reflected in inflationary figures.

And it looks like for the rest of the year we would expect to see similar inflationary impulses, at least until we pass the anniversary of Brexit and that's the sudden sharp weakening of the pound after which what we call base effects, so the impact of a sudden move in one of the input prices will start to come out in the wash and we think from then you'll likely see a sort of degrading again in inflation back to sort of relatively low levels.

Wall: Why should investors care about inflation? I mean, the most obvious one is, savers look for a rate of return which is more than inflation so they actually get a real rate of return. Other than the way that it impacts yield, what sort of considerations should we have as investors when it comes to inflation?

Klempster: Well, I think, if you take a step back and look at the environment we're moving into over the next sort of 10 or 20 years, which is an environment where savers and investors who are on the hook for their own pensions, inflation is key. I think it's the biggest known risk faced by investors. It's not volatility or Brexit or something happening in North Korea. These things create noise and volatility in portfolios.

But what actually can fundamentally destroy value for investors and in a very sort of sneaky way, it's underhanded, you don't see it coming. But inflation, if you leave unchecked, it picks your pocket year after year after year and your ability to spend in retirement is massively diminished compared to what it is when you save it. So, you have to be very careful about inflation.

Wall: That's a really good point, because I think 2% doesn't sound like much, but chipping away compounding over time it actually erodes a significant amount of your money. So, how can we protect our portfolios from it?

Klempster: Well, the good news is that if you believe in the asset classes available to us today, you should get rewarded in excess of inflation from all of these asset classes. Even cash historically has beaten inflation in the U.K. The problem is, it doesn't all happen at the same time or consistently. It comes and goes. The time series are very bumpy, very volatile compared to inflation which is generally quite stable and sort of relentless in that sense.

So, the key is to focus on the amount of risk you're able to take and then think about how much you'll likely to be able to beat inflation by with that sort of level of risk through many cycles, diversify portfolios to give you a whole suite of different return drivers in the same place and then I suppose be patient as well because inevitably investments bounce around either side of an inflation time series. But the longer you can leave your investments to work for you, the greater your chances of beating inflation.

And so, that coupled with an ability to be active around asset allocation. So, down-weight the asset classes that are getting expensive; over-weight those that are becoming cheaper also stacks things in your favour looking forward.

Wall: James, thank you very much.

Klempster: Thank you.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Emma Wall  is former Senior International Editor for Morningstar

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