Summary:
Tom Stevenson giving reasons why inflation matters to investors and the economy, and what one should do to protect himself against it. Notes that the present situation is different from the 70s (some prices going up fast, others falling). Inflation matters because it acts as a tax on savers and investors (cfr. Rule of 72), and because it has a negative impact on corporate profits (when the rising costs of inputs can't be passed on to the customer due to competitive environment). People must save more, assess the extent to which stocks in portfolio enjoy pricing power, and older investors should consider extending the time they remain exposed to assets that traditionally perform better in inflationary periods, rather than move into less risky assets like bonds and cash as they approach retirement. (Published: 19/06/08)
Notes:
- Inflation at 3.3%
- Governor of BoE had to send explanatory letter to Chancellor
- Mervyn King: “there are good reasons to expect the period of above-target inflation we are experiencing now to be temporary”
- While the headline inflation figure might exceed 4% later this year, King predicts, an already slowing economy will soon bring headline inflation lower again.
- argues that we are seeing a one-off step change in commodity and energy prices, but that this should not be confused with inflation because there is no generalised rise in prices and wages
- situation is more complex than a simple return to 70s
- Fuel prices may have risen by 19.5% year-on-year in May and vegetables by 7.2%, but audio-visual equipment fell by 14% and clothes were 6.7% cheaper
- Input prices for manufacturers may be surging but house prices are falling.
- "All of us must hope that the Chancellor’s reading of the prices outlook is on the money, because the inflationary genie is notoriously difficult to squeeze back into the bottle once it has escaped. The economic, and social, pain of doing so is heavy."
- Why inflation matters
- Acts as an insidious tax on savers and investors.
- From Barclays Capital’s Equity-Gilt study:
- between 1972 and 1981 the cost of living rose three and a half times as inflation ranged between 7.7% and 24.9%
- even between 1982 and 1991, when inflation moved in a much lower range between 3.7% and 9.3%, prices rose by 64%
- divide 72 by the expected growth rate to see how many years it will take to double a given sum. Conversely divide 72 by the expected inflation rate to see how many years it will take to reduce by half the purchasing power of a given sum
- shows that a 4% rate of inflation will reduce by half the value of a given sum of money in just 18 years
- at 6%, that erosion of value takes just 12 years
- If you are retiring on a fixed income and live for another 25 years, you might therefore expect your purchasing power to fall by three quarters over the period of your retirement if inflation is allowed to return to 6% and stays there
- Negative impact it has on corporate profits
- increasingly competitive global marketplace
- companies struggle to pass on higher costs
- recent rise in raw material costs poses a serious threat to margins
- In May, factory gate (output) prices rose by 8.9% but input costs soared by 27.9% (5).
- manufacturers caught in the middle (and their shareholders) are being forced to swallow the difference.
- What should investors do to protect themselves from its insidious effects?
- save more
- although the spiralling cost of filling the car and the weekly shop makes this increasingly difficult for most people.
- assess the extent to which stocks in portfolio enjoy pricing power
- ability to pass on input costs to the end customer will be a key determinant of earnings and dividend growth if we return to a more inflationary environment
- e.g. infrastructure: can offer predictable cash-flows from non-cyclical services
- e.g. water supply
- toll-roads and bridges
- can be a hedge against rising prices because people who have to use these facilities are unlikely to stop just because the price goes up a bit
- other traditional inflation hedges are utilities and tobacco.
- mining and oil companies?
- might seem an obvious play in light of high commodity and energy prices
- but: if King is right and the economy does slow significantly, the outlook for those prices might not be as secure as some hope.
- Sectors that are likely to underperform against an inflationary backdrop
- those trapped between rising prices and powerful customers
- e.g food producers
- won't receive much sympathy from their customers
- e.g. the supermarkets
- operate in a cut-throat competitive environment
- e.g. clothes retailers
- especially at the low-cost end
- older investors should consider extending the time they remain exposed to assets that traditionally perform better in inflationary periods
- in particular equities and property
- rather than move into less risky assets like bonds and cash as they approach retirement, as is tradition
- fixed income is a bad idea in inflationary times
- "If the Bank of England is really suffering from the delusion that a little bit of inflation won’t hurt, then fixed incomes are going to look progressively unattractive. Just ask the tanker drivers."
