Inflation is the rate at which the prices for goods and services in an economy increase and consequently the rate at which the value of money falls. When the price level increases, the real value of money (or ‘purchasing power’) falls and, if wages don’t keep up, the standard of living for people may fall too.

Inflation can usually be categorised as either ‘cost-push’ or ‘demand-pull’. Cost-push occurs when the price level rises due to increases in costs, like wages and materials, which are passed onto the consumer.

Demand-pull inflation occurs when demand outpaces supply and leads to higher prices.

Despite the impressive returns for those who have stayed invested in bonds and/or equities in recent years, there is little sign of euphoria. Investors remain nervous and many choose to hold significant amounts of cash. While this appears to be a conservative strategy, it is in fact a rather risky one.

The obvious problem is that with interest rates at record lows, you receive virtually no interest on your capital. The bigger problem is inflation.

As inflation is running well above the level of interest rates, the supposedly conservative strategy of putting money in  the bank is destroying your purchasing power at a rather alarming rate. Figure 1 shows what has happened to £10,000 deposited in a bank since 2007. We assume the deposit is receiving interest at the level of the bank rate set by the Bank of England (BoE).

As inflation has been higher than the interest you have been receiving, your purchasing power has been declining. The black and purple lines in the chart show the impact over time of this problem. The black and purple lines show what your £10,000 is worth after adding the interest you receive and considering CPI and RPI respectively.

If your investment manager had reduced the purchasing power of your capital by that amount over the last decade you would not be happy.

The effect of the pandemic

During the Covid-19 crisis, economic output has fallen sharply and so has inflation. However, as a result of unprecedented levels of fiscal and monetary stimulus, inflation expectations have now eclipsed their levels just before the pandemic.

The future for inflation?

Whether or not inflation resumes at a level which is higher than we have been used to over the last decade, we think that recent changes to monetary and fiscal policy, at least create upside risk to inflation. That alone would be enough to cause significant disruption and rotation in markets given the extent to which assets prices have become underpinned by low inflation and low interest rates.

The bottom line

There are a number of questions and uncertainty around inflation. Only by carefully monitoring how the economy emerges from the pandemic and how consumers and corporates adjust to the new normal will we be able to make the right decisions about investment options.

That said, we expect a diversified global equity portfolio, or a balanced portfolio of equities, corporate credit, property, infrastructure and other real assets and government bonds, to continue to provide investors with capital growth in real terms. In fact, such portfolios may be less risky to your financial well-being than sticking your money in the bank.

Please note the value of investments can go down as well as rise.

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