If you’ve been following news around financial markets over the last few days, you have noticed a sell-off in global equity markets. This has come as a response to a recent pick-up in inflation, most notably in the US.
The likeliest explanation for the sell-off is that equity investors are concerned that faster-than-expected inflation will force the hand of Central Banks, moving them to tighten monetary policy more quickly than they had anticipated or planned for. The question for investors, then, is what the sell-off means for markets in the short and medium-term, and whether the rise in inflation will be enough for Central Banks to act.
Our view on the sell-off
As it stands, we are confident that the spike in inflation we’re seeing at present will prove to be transitory. Part of the jump can be attributed to “base effects”, i.e. the comparison with the very low levels of commodity prices that we saw, for instance, this time last year.
If you look at the latest Consumer Prices Index release, the strong month-over-month increase in headline figures has come primarily in areas hardest hit by the pandemic – think rental cars, airfares, eating out, and hospitality more broadly, for example. It stands to reason, we think, that this effect will be short-lived.
Another way to look at it is that inflation is clearly a demand-driven metric. The past few days has told us something important about the potential effect that higher inflation can have on markets – demand-driven inflation is a sign of a strong economy and, while this may have a negative impact on bonds, it doesn’t necessarily mean that equity will suffer.
Most importantly, however, are considerations around the labour market. In the US and elsewhere, the jobs market is still very much under repair, with levels of employment still some way off their pre-Covid-19 levels. It appears as though the Fed will focus on the recovery of the labour market first and foremost, which means erring on the side of caution and avoiding the risk of tightening policy too early. Whatever the outcome may be, inflation is likely to remain an important focus for financial markets in the coming months.
How inflation changes the way we save
When it comes to how individuals protect and grow wealth for the future, inflation has a key role to play in dictating the best course of action. Traditionally, holding one’s wealth in cash has been a safe bet for steady, inflation-beating growth, considering that cash and deposits paid enough interest to fend off if not offset inflation. During periods of low inflation and high interest rates, cash is a perfectly viable way to hold wealth over the long term.
In situations where the opposite is the case – high inflation and low interest rates – holding wealth in cash is a surefire way to lose real value over time. As prices rise and cash accounts stagnate, the purchasing power of your savings can be worth significantly less over a long enough timeframe. In the charts, you can appreciate the effect of rising prices on £20,000 over 20 years. The inflation rate considered is 2%, which is close to the medium-term inflation target of most central banks. When the price of goods and services grows, the same amount of money will be worth less in terms of purchasing power. Even if the nominal value of money remains the same, the real value of money will decrease dramatically.
With a 2% inflation rate over 10 years, £20,000 will be worth the equivalent of £13,450. And this only considers the general rate of inflation, measured on a bundle of different goods and services. Specific items can register an even higher rate of inflation, which will decrease the future value of cash when used to buy them. Take the example of housing, the value of which has grown considerably more then 2% a year in most large cities over the past 10 years. This means that if your goal is buying a house, your money kept in cash would have depreciated much more than the general rate of inflation over this period of time.
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Recently, we performed a study comparing the performance of a hypothetical Cash ISA with that of a hypothetical Stocks and Shares ISA over a 10-year period. When inflation was taken into account, cash accounts ended the decade with a real value that was considerably less than when it began. By contrast, the three investment accounts we synthesised all ended the decade with significant returns, to varying extents. Yes, the volatility of these accounts was considerably higher than that of cash, but they were ultimately incomparably effective at beating inflation.
This is why savers should be keeping on top of the news of rising inflation. Yes, there is a chance that heightened levels of inflation will have an impact on financial markets – there is, however, a certainty that high inflation will eat away at the real value of cash savings over time, providing that interest rates stay low.
Other factors to consider
There are a couple of other factors to consider when deciding where to keep your wealth for long term protection and growth. The first speaks to how people can manage the impact of crises on their investments. Ultimately, it comes down to time. With a long enough horizon for investing, the impact of temporary crises can be effectively smoothed out.
As a wealth manager focused primarily on medium and long-term outcomes, we’re able to view fluctuations or difficulties in the markets from a position of relative detachment. We make changes to our portfolios to protect them or to capitalise on trends, but we are not subject to reactive trading or short-term speculation. At Moneyfarm, our investment specialists think in terms of years, not months.
Equally important for a robust investment portfolio is diversification. Financial news will often focus on individual businesses, assets or geographies that are over or underperforming, but this can be a distraction when putting together a portfolio to stand the test of time.
Our investments are spread across a number of industries, geographies, asset types and currencies. In theory, this means that if one struggles, another will outperform to pick up the slack. The ability to absorb poor performance in certain areas comes from the myriad other investments balancing them out. It’s because of diversification that we can monitor the inflation situation closely, but are unlikely to be forced into making any immediate alterations to the composition of our portfolios.
All of this is to say that inflation is, of course, one of the risk factors we are monitoring in the short term. There is, however, no need to be worried, particularly in the context of 10 months of growth.
What we advise you to do is to consider the long term implications of a potential rise in inflation over the medium to long term. We’re coming out of a 20 year period in which inflation has been under control. This hasn’t always been the case and, despite the best efforts of Central Banks, it might not be the case in the future. Particularly if you’re sitting on too much cash, the best course of action is to act in advance to protect your capital for the long term.