Prices are rising at their fastest rate for five years. Annual inflation rose to 3% in September, and stayed at this rate in October. This led to the Bank of England increasing interest rates in early November for the first time in a decade.
Rising prices can be challenging for savers and investors, because it reduces the spending power of your money over time. Inflation running at 3% a year will almost halve the value of your money over 20 years. Even over shorter periods, it can have a marked effect. So how can you help counter the effects of rising inflation and low interest rates in your investment choices?
Boost cash returns
Inflation is bad news for cash savers, particularly as interest rates are so low. Many will welcome further interest rate rises, which should prompt banks and building societies to increase savings rates. But rate rises are likely to be minimal and gradual – with gains likely to be wiped out by still higher inflation. People with cash savings should monitor rates carefully. Be prepared to switch accounts to take advantage of any better deals that appear over the next few months.
Bad news for bonds
Higher interest rates and rising inflation can have a negative impact on fixed-interest investments – such as corporate bonds and gilts. As the name suggests, fixed-interest investments pay a fixed return, which can look less attractive if interest rates rise significantly. This can weaken demand for these investments, lowering the price at which they are traded. Higher inflation can also reduce the value of fixed income over time, further reducing demand for these investments.
All this doesn’t mean you should avoid bonds completely; they offer reliable income streams and are a valuable part of a diversified portfolio. But be aware that market conditions could cause valuations to slip in the near future.
Stick with the stock market
Shares can be a good hedge against inflation, because companies have the potential to grow their profits broadly in line with inflation. However, share prices can be volatile, particularly over shorter timeframes. Where possible, investors should diversify and hold a range of shares in different markets. In periods of higher inflation, investors tend to favour secure companies with consistent earnings that pay reliable dividends. These types of company shares are often found in equity income funds. Higher inflation can impact returns on some equities. For example, retailers can find that their margins come under pressure if the prices of wholesale goods rise. Certain sectors, however, can benefit from higher inflation – for example, utility companies.
Consumers still need water and electricity, and some companies are able to link their prices to inflation.
Meanwhile, higher interest rates are good news for banks and other financial companies, but they are generally bad news for companies with high levels of debt, such as most house-builders, because higher interest rates increase their costs.
Investors should be wary about making too many changes based on predictions or short-term market movements. Concentrate on longer-term goals, and assume inflation will be a factor over time. For most investors, the best way to beat inflation is to build a diversified portfolio that includes equities for growth as well as more secure assets, like bonds, to provide diversification and help manage risks. If you’d like to review your investments, please let us know.
The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investing in shares should be regarded as a long-term investment and should fit in with your overall attitude to risk and financial circumstances.
Tags: Asset Allocation