(Bloomberg Opinion) -- Virgin Media has been sending customers letters telling them their prices are going up. Really going up. This year they, will be up 12% and from April 2024 they will go up by the RPI rate of inflation (which is usually a good one percentage point more than the government’s official measure, CPI), plus an additional 3.9%. Every year.
That’s audacious of Virgin, and irritating for hard-pressed consumers. But it’s also a reminder of just how sticky inflation can be: If everyone put their prices up by five percentage points more than the previous year’s inflation every year, how could inflation ever fall?
The truth is, says the latest Credit Suisse Global Investment Returns (a must-read for City people), is that once inflation reaches 8%, and is front and center in the minds of all price-setters and wage negotiators, it takes multiple years to revert to target. Thinking anything else is “overly optimistic.”
So, with inflation near or above 8% in a large number of developed countries, what is an investor to do?
Buy equities, of course — they are famously a wonderful hedge against inflation. The Credit Suisse report — authored by Elroy Dimson, Paul Marsh and Mike Staunton — runs through the record. It is a good one. Between 1900 and 2022, stocks in the 21 countries with continuous records over the period have more than beaten inflation. The US market has produced an average annual real return of 6.4%, while the rest of the world has seen a real return of 4.3%. We would, I think, all be happy to know we could lock those kinds of numbers in.
On then to the bad news. There has long been a market rule of thumb that claims equities only like inflation up to around 4%. Beyond that, they don’t like it at all. It turns out there is truth in this. Dimson, Marsh and Staunton divided their data by years when inflation was in the top 5%, the next highest 15% (which saw average rates of around 7.4%), the 15% below that (4.1% to 7.4%) and the 15% below that (still above 2.7%). Here, the results were rather different.
In the top 5% of high inflation years, equities fell an average of 9.6% in real terms (bonds fell 24.5%), and in the next 15% they managed a rise of a mere 0.7%. Times of stagflation (which investors are right to fear) were nasty too: In low-growth, high-inflation environments, real equity returns were -4.7%.
These miseries might be about the inflation itself (creating loss of confidence and uncertainty), but the cure (rising interest rates) quite clearly plays its role too: In the UK, for example, equities have historically produced a real return of 0.7% during periods of rising rates, but 8.5% in periods of falling rates. In the US, those numbers are 2.6% and 9.4%. You get the point. In the main, whatever else is going on, rising rates = stock market misery (see all markets in 2022).
That said, there is also evidence that the cheaper equities are to begin with, the more likely they are to outperform in inflationary times, a thought that should immediately focus all minds on the UK market. Twenty years ago, says Ian Lance of investment organization Redwheel Asset Management, it was perfectly normal for investors to have too much of their assets in both equities and in the UK (think 55% in UK equities). But today things have swung far too far in the other direction.
Most UK funds that consider themselves balanced (pension funds or wealth manager model portfolios, for example) are likely to have only 10%-15% of their assets in the UK equity market. That reduction of equity exposure to the UK — and the relentless selling it suggests — “potentially explains why returns have been lackluster since 2000.” Even when the FTSE 100 hit a new high of 8,000 last week, that represented a rise of only 15% since the late 1990s (the US is up 180% in the same period).
This makes little sense. After all, says Lance, “one of the immutable laws of investing is that valuations and subsequent returns are inversely related.”
If you have money in the US and no money in the UK, you are betting that this time it will be different — when it never is. The UK also offers one of the few things (gold aside) that really is a hedge against inflation: dividend yield. The UK is not just one of the cheapest markets in the world, it is one of the highest yielding. The FTSE 100 yields 3.5%, but look inside and you will see the likes of Glencore Plc on about 8%, HSBC Holdings Plc on 4.3%, Rio Tinto Plc on 6% and Vodafone Group Plc on nearly 8%.
You might also look at the UK’s many “dividend hero” investment trusts, so-called because they have put their dividend up every year for at least 20 years and have good incentive to keep doing so. Many offer yields over 4%. These yields are far from guaranteed, of course, but they still offer a pretty good starting point for anyone trying to hang on to their purchasing power.
Equities might not be a perfect inflation hedge. But buy cheap and focus on dividends, and your holdings should have some hedge about them. This is maybe why the FTSE 100 is outperforming the S&P500 so far this year.
Finally, a note on your savings. Before you move on to adjust your equity portfolio, there is something even easier you can do to help your future self out: Check the interest rate on your savings account. There has been little point in bothering with this for years. Pennies do of course eventually turn into pounds, but it has been hard to drag up the enthusiasm to do the admin to move your money around when the differential between offerings is 0.01% or less. Now it is more like 2 to 3 percentage points, and your enthusiasm should be rising fast.
You can get a one-year bond from NS&I at 4%. Or you can really push the boat out, go to Atom Bank and get 4.3%. These aren’t numbers that are likely to beat inflation in 2023, but they will make a firm dent in it — in exchange for very little effort on your part. Get started now and you might be able to afford to keep your Virgin subscription, should you still want to.
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To contact the author of this story:
Merryn Somerset Webb at [email protected]
