It feels like everything is going up in price doesn’t it? It feels that way because by and large, it is! We are seeing inflation levels that have not been seen for many a year and this is causing concerns all around the world amongst central bankers, economists and… ordinary people. We are the ones that feel is most, after all. This month, let’s take a look at what inflation is and how it may affect your portfolios. This is going to be a bit dull at first, but in order to build up the ending, I need to take you to the depths of dull first! Bear with, darling…
Definition: Inflation is a general increase in the prices of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduction in the purchasing power of money (Wikipedia)
The Bank of England measure inflation using a ‘basket of goods’ of around 700 things that we buy regularly. These include smaller things like a bus ticket (not been on so many since Covid, have you?) or a loaf of bread. To the more expensive things like a car or a holiday. This is known as the Consumer Price Index (CPI). As of 17th of June the Bank of England CPI published rate was 9.4%, way above their target of 2%.
In May, the Bank of England published this chart, showing their expectations of future inflation. Remember, like every other forecaster whether it be economic, weather or football results it will be wrong!
How this could affect you if inflation was just the historical average of 3%
How inflation arises
There are two ways inflation is caused:
“Demand-Pull” Inflation
This is where the amount of money in the economy increases at a rate faster than the size of an economy. Essentially, there is more money but no more demand. This pushes prices up as people can afford to pay more and so ‘bid up’ the price.
Recent examples of this include:
Central Bank Printing money – this has been happening since March 2009 and only stopped in December 2021
Covid Furlough Scheme – The government dramatically increased spending on furlough schemes, thus distributing a large amount of money into the economy but with no growth.
Wars – Being at once the brightest and stupidest of species, it seems that someone is always up for a fight, whilst most of us are not, we all get dragged in. The invasion of Ukraine has led to a disruption in the production of goods leading to an increase in prices. So did Covid.
“Cost-Push” Inflation
This is where the cost of component parts needed to make goods increases. For example, the cost of energy.
Recent examples of this include:
War in Ukraine – the economic sanctions on Russia are meeting a response in a rise in the cost of oil and gas, as they are a massive producer of these commodities. This is causing prices around the world to increase for energy and everything produced on earth needs energy.
The blocking of the Black Sea is preventing grain from being exported. This is pushing up the cost of food as Ukraine produces such a large percentage of world grain supplies.
Why does this matter?
Inflation is important as if it is too high then it is eroding the purchasing power of your money. This means, that you are buying less and less goods with every £. If you hold assets in cash or fixed interest bonds, then it is extremely likely that you are earning less than the rate of inflation and as such next year, your money will buy you less. This is the insipid, creeping effect of inflation. In the worst examples, such as the Weimar Republic in Germany in the early 20’s a loaf of bread went from costing 160 marks in late 1922 to 200,000,000,000 marks (nope, I don’t know what that is in words either) by the end of 1923. In other words, if a loaf of bread cost £1 today, next year it would cost £1,250,000,000. And that, my friend, is why holding money in your bank is extremely bad for your wealth! This is a true example that has happened. Very rarely, but it has. The events in Mugabe’s Zimbabwe offer similar examples.
This means, that people that have saved their whole lives can very quickly have the value of their savings eroded. Particularly those in retirement on fixed incomes that do not increase with inflation. For example, the long term average inflation rate is 3%. If your income does not increase each year, then in effect it is going down each year. The cost of a £1 loaf of bread would be £2 within 23 years. A £1 increase doesn’t seem much, so let’s do on average house prices. In April 2022, the average UK house price was £281,000. In 23 years at average inflation rates that would be £555,000. It’s a bit more noticeable then, isn’t it?
What can be done about it?
On a macro level, this means tightening of money supply. The Bank of England, Federal Reserve and other central banks have started to increase interest rates in order to control the supply of money, thus helping to stifle inflation.
However, that’s all out of our circle of influence, isn’t it? So let’s look at how we can protect ourselves against inflation. If we take a logical thought pattern, wages must be rising in order for people to continue to be able to afford the higher prices that are produced by inflation. If that’s true, then the companies that pay those wages must be making increased profits. Therefore, as a shareholder in those companies, you can also expect a higher distribution of dividends or capital growth in the value of those companies.
I call dividends “the inflation killer”
Since 1960, the consumer price index is up 9 times.
In the same time period the cash dividends of S&P 500, i.e. 500 biggest companies in the United States, are up 30 times. And that’s just dividends and ignores capital growth.
To repeat, since 1960, the CPI has been up 9 times, whereas the dividends has been up 30 times.
What does this mean for you? If you owned these great companies, you would have had much more income than the rising inflation. 21 times extra. You didn’t maintain your lifestyle, you didn’t get just enough, your income compounded at a higher rate.
So we know that since 1960, the dividends of S&P 500 have gone up 30 times.
What about the value of the shares in the S&P 500 itself?
The answer is 70 times.
What does this mean to you? If our income is rising at a much greater rate than the cost of living, than this means that your investments will grow, and you will be able to leave a legacy for the people that you care the most.
Rising equity values over time have given you even more room to:
increase withdrawals, and
build wealth that you can leave to the people you love.
Investing in the great companies of the world means you can benefit from this. It will not be an easy ride, there will be times when you think you ae doing the wrong thing, and that your investments are down in capital as well as in purchasing power. But if we are honest with ourselves, do we believe the 7 billion people that get up every day and go to work to work out how to be more efficient, or innovating new products will stop? I certainly don’t. And that’s how wealth is produced.
The real inflationary target we should be reaching
I was reminded this on a recent trip to Ireland to see a friend the real reason we shouldn’t be too gloomy about this economic inflation. We were in the rock pools by the sea in a place called Skerries, north of Dublin. My friend and his 3 kids had just smashed back the largest of ice creams as the sun started setting and then we went about finding some beachside fun. With my mate’s 7 year old son, we were trying to run up the fairly steep sea wall, sometimes falling back and sometimes reaching the top. After a while, we got out of breath (I did it once, he did 10-12 times!) and as we walked further along the beach he turned to me and said ‘Stevie, fun is the funnest thing!’. I thought, you know what kid, you’re right! The best things in life are free and we need to do our best to apply inflationary pressures to them.
Let’s inflate:
the time we spend with the people we love
the time we spend doing what we love
the amount we travel
the time we spend outside
the time we spend aimlessly thinking about the smallest things.
We hope you found this article interesting and useful.
If there are any specific topics you’d like us to cover in an upcoming issue, please let us know by emailing support@lucentfinancialplanning.co.uk and we’ll see what we can do!
This article does not constitute financial advice. We recommend that you speak to a qualified financial adviser for advice tailored to your individual circumstances and goals. Financial markets may go up or down, and you are not guaranteed a return on your investment. Past performance is not necessarily a guide to future performance.
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