I think it’s pretty clear that inflation is here to stay for a while – and we’ll all lose out as a result. Inflation is a useful tool for heavily indebted governments like the UK’s, as it erodes the value of their debts, so it’s hardly surprising that the Bank of England hasn’t put up interest rates to try and bring rising prices under control. But higher interest rates would have limited effect on this type of inflation anyway, as it is a result of imports becoming more expensive, rather than rising wages.
So far we’ve seen price rises mainly in commodities, food and fuel, but there are clear signs that imports of Chinese manufactured goods are going to become more expensive as wages there rise.
The challenge is therefore to identify those investments most likely to withstand ongoing inflationary pressure. Most investors are feeling pretty risk-averse at present, so they are reluctant to look to the stock markets and instead have been looking for inflation-proof safe havens. Basically that means inflation-linked gilts and cash products such as the NS&I index-linked bonds.
But inflation-linked gilts are not cheap and continuing uncertainty surrounding the strength of Eurozone governments means they carry an increased risk of capital loss. When it comes to cash, NS&I’s index-linked bonds are particularly attractive because they’re tax free, but they are not currently available. BM Savings has a taxable three or five-year index-linked bond that can be held in an Isa to keep the returns tax-free – but you won’t beat inflation by more than 0.5%. But index-linked products such as that from the Post Office are taxable, which means basic and higher rate taxpayers have no chance of keeping pace with inflation.
So what are the alternatives? Historically, returns from both equities and property have beaten inflation, but of course those are the areas that carry more risk – particularly property, which is a much less liquid investment than equities. However, both are standing on generally attractive valuations at the moment, and investors should certainly consider them.
Most of equity investors’ total returns over the past five years have come from dividends, so I like funds investing in dividend-oriented businesses that will provide investors with an income stream even if there’s no capital growth in the short term. You won’t beat inflation through dividends alone at present, but over the longer term capital appreciation should kick in to boost total returns.
The UK equity income sector is an obvious place to look, but there are also growing opportunities to find decent income-producing international funds, and even Asian and emerging markets offerings, as emerging markets become increasingly mature and companies start to reward investors with regular payouts.
Dividend-paying businesses are also a good way to maintain some investment presence in Europe in the face of its present problems. After two major crises in the past decade, the corporate sector is in reasonable shape and sitting on good levels of cash, despite the current political and economic troubles. The major danger is of wider economic slowdown, but otherwise Europe offers good prospects for income-seekers.