Why inflation matters - and what you should do about it

By Tom Stevenson, 19 June 2008

In the second of his new weekly columns for Fidelity, Tom Stevenson looks at the implications of this week's higher than expected inflation figures.
This week’s inflation data were shocking. But for anyone who can remember the dark days of the 1970s they were less worrying than the Bank of England’s relaxed attitude to the latest figures.

The jump in the consumer price inflation (CPI) benchmark to 3.3%⁽¹⁾ triggered an explanatory letter from Bank governor Mervyn King to the Chancellor. However, if anyone expected humble pie (“sorry, Sir, we cut rates three times and shouldn’t have”), they were disappointed.

The governor said “there are good reasons to expect the period of above-target inflation we are experiencing now to be temporary”⁽²⁾. While the headline inflation figure might exceed 4% later this year, King predicts, an already slowing economy will soon bring headline inflation lower again.

He 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. Incidentally, he would have been unaware of the Shell tanker drivers’ inflation-busting pay-deal when he wrote this.

Look more closely at the latest figures from the Office for National Statistics (ONS) and you can see that the picture is indeed more complex than a simple return to the bad old days of platform shoes and lava lamps.

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⁽³⁾. Input prices for manufacturers may be surging but house prices are starting to head south. Faced with such conflicting evidence, who’d be a central banker?

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.

Inflation matters

Inflation matters for a number of reasons. First, it acts as an insidious tax on savers and investors. Between 1972 and 1981, according to Barclays Capital’s Equity-Gilt study, 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%⁽⁴⁾.

An arithmetical rule of thumb known as the Rule of 72* 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 (very likely), 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.

The other reason why inflation is such bad news for savers and investors is the impact it has on corporate profits. In an increasingly competitive global marketplace in which companies struggle to pass on higher costs, the 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). The manufacturers caught in the middle (and their shareholders) are being forced to swallow the difference.

Protection from inflation

So if the dragon of inflation is stirring once more, what should investors do to protect themselves from its insidious effects?

The first, unwelcome, conclusion is that they must save more, although the spiralling cost of filling the car and the weekly shop makes this increasingly difficult for most people.

More realistically, investors should look at their portfolio and assess the extent to which its underlying stocks enjoy pricing power. The 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.

One obvious area to consider is infrastructure, which can offer predictable cash-flows from non-cyclical services like water supply. Other infrastructure activities like toll-roads and bridges can be a hedge against rising prices because people who have to use these facilities (to go to work, for example) 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 are those trapped between rising prices and powerful customers. Don’t expect food producers to receive much sympathy from their most important customers, the supermarkets, who themselves operate in a cut-throat competitive environment. Clothes retailers look vulnerable too, especially at the low-cost end.

Finally, older investors should consider extending the time they remain exposed to assets that traditionally perform better in inflationary periods – in particular equities and property.

Historically, retirees have tended to move into less risky assets like bonds and cash as they approach retirement, but increasing longevity suggests we should rethink those assumptions. 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.

*The rule of 72: 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.

^{(1) Source: Office for National Statistics website - May 2008
(2) Source: Bank of England website - 16 June 2008
(3) Source: Office for National Statistics website – 17 June 2008
(4) Source: Barclays Equity-Gilt study 2008 - 13 February 2008
(5) Source: Office for National Statistics website – 9 June 2008}

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