UK inflation and how to invest to safeguard your wealth

Wednesday, Sep 14 2011 by

UK consumer price inflation came in at 4.5% in August 2011 in what has been a series of numbers that are way above the Bank of England’s 2% inflation target. For investors and savers this represents an insidious assault on their wealth, but there are investments tailored to dealing with inflation. By Justin Pugsley

The hunt for inflation-protected investments has been on for nearly two years and it’s not hard to see why with the old retail price index measure putting inflation at an even worse 5.2% for August. In fact UK inflation has been consistently above 2.4% since December 2009 using the RPI index and over 3% since January 2010 under CPI and so far this year it has been generally higher than in 2010.

Clearly, fighting inflation is not the Bank of England’s big priority right now, as it is trying to reinvigorate the flagging economy. Baring a major economic recession, inflation looks as if it is here to stay for the foreseeable future. Though, admittedly it’s nothing like the 1970s when inflation topped out at 24.2% in 1975, but 5% inflation does nonetheless erode wealth. 

The good news is that there are a growing number of investments designed to protect your wealth against inflation, but unfortunately they all involve different degrees of risk.

Inflation protected savings accounts

The safest and easiest one on the market is the Post Office, which has a three-year savings account with the interest rate linked to inflation at a rate of RPI + 0.5% a year and a five-year one at 1.5% a year. Unfortunately, the interest is taxable, which made the government’s National Savings & Investments, inflation-linked savings accounts so brilliant, the interest wasn’t taxed, but sadly they’ve been withdrawn. Also, the Post Office scheme is actually operated in conjunction with the Bank of Ireland, but account holders are covered up to GBP 85,000 under the UK Financial Services Compensation Scheme if it was ever to go bust in the UK.

But keep a look out in the personal finance sections of the main newspapers as other financial institutions occasionally launch inflation-linked savings accounts. Recent ones include the Cambridge Building Society, Yorkshire Building Society and Santander. But these investment accounts seem to come and go quite quickly. But do study the terms and conditions carefully before committing your money.

From here onwards the investments described do involve varying degrees of risk, which means you could lose some or all of your capital if they wrong.

Inflation-linked bonds

Another route is to buy British government issued index-linked gilts or ‘linkers.’ These are safe in that the UK holds the highest credit rating and has a long history of honouring its debt obligations. These can be bought via a stock broker. The problem with these bonds is that they’re traded in an open market meaning that their value is constantly changing and many analysts consider them to be currently very expensive and as such they pay out a relatively low yield or level of interest. There’s the risk that the market will turn against linkers, which would see holders see a fall in the value of the bonds and potentially lose capital. That could happen if inflation expectations or inflation itself actually fell. For the un-initiated it is probably best to stay away from these assets.

Also, the interest they pay is taxable unless they’re held in a ‘tax efficient wrapper’ such as an Individual Savings Account (ISA) or a Self Invested Pension Plan (SIPP), which are available through stock brokers.

An alternative is to buy corporate bonds with coupons – or interest rates – linked to inflation as they generally pay out a higher rate of interest or yield than linkers. UK electricity and gas grid operator, National Grid, for instance issued a 10-year bond that pays 1.25% above RPI. Like with Linkers these can be bought through a stock broker.

However, corporate bonds do carry the risk of the issuer defaulting if they get into financial trouble and are therefore not as safe as deposit accounts or UK government bonds. Though, National Grid, can be described as having a very safe business. Other issuers of inflation linked bonds include retailer Tesco, another safe business.

Inflation-linked funds

But for people who are not expert in trading bonds the best course of action is to invest in a fund that pools lots of different bonds together. There is the M&G UK Inflation Linked Corporate Bond Fund, which is geared to investing to protect the value of capital and generate a return above inflation. 

There are a great many bond funds out there and personal finance magazines such as Money Observer have back pages devoted to tracking these funds and their performance.

The risk with funds, other than they go up and down in value, is that you are investing in the ability of the fund manager to generate a positive return and they do that with varying degrees of success. So picking a good fund manager is key, which is why observing performance tables is important and long-term good performance is best. Funds can be invested in via a stockbroker. 

Another alternative is to invest in an Exchange Trading Fund. The benefit of these is that they are designed to track a basket of assets whether they be stocks, bonds or commodities and they are traded on stock exchanges.

In the UK, there are inflation-protected ETFs such as the iShares UK Pound Index Linked Gilts Fund and the iShares Global Inflation-Linked Bond Fund just to name two of them. As there’s no active asset selection by a fund manager, they only invest in a predefined basket of bonds, they also tend to have lower charges than most ‘actively’ managed funds.

Shares that could benefit from inflation

The other route is to buy shares in companies that have relatively high yields or dividend pay-outs and that benefit from inflation. In the UK, sectors that do well from inflation include transport, utilities and supermarkets.

Railway companies should do particularly well, as long as unemployment doesn’t soar, as they’ve been allowed to raise train fares by an eye watering RPI + 3% a year for the next three years, admittedly so the government can reduce subsidies while keeping investment going into rail. So if you can’t beat them, then maybe join them! Stock market listed companies that have railway franchises include: Go Ahead Group, National Express Group and Stagecoach Group.

Gas and electricity groups that price their services at above inflation rates include National Grid, Centrica and Scottish & Southern Energy and then there are water companies such as Pennon Group and United Utilities among others.

Supermarkets could also be beneficiaries of inflation, in particular for rising prices of food items, which boosts profits. The problem for supermarkets, which increasingly sell lots of non-food items like TVs like Tesco, is that inflation also reduces people’s spending power so they’re less likely to buy non-essential consumer items.

Morrison Group is probably the most heavily focused on food, then there’s J Sainsbury and lastly Tesco, which has a rapidly growing overseas business.

It is important to pick stocks with good balance sheets, ones that can increase their dividends every year and then to reinvest those dividends. The latter is what ultimately gives you long term capital growth.

Then of course there are a number of funds that invest in high yield stocks, such as the Newton Global Higher Income Fund, Schroders Global Equity Income Fund, Blackrock UK Income Fund, Shires Income, British Assets and there’s an ETF called: iShares FTSE UK Dividend Plus Fund. Again magazines such as as Money Observer have tables that track the performance of different types of funds.

Also, shares are best held in tax-efficient wrappers such as ISAs and SIPPs.

Invest in commodities to offset inflation

Much of the inflation in the UK is derived from high commodity prices for items such as oil, grains and meat. Therefore one potential way to protect one’s assets against inflation could be to simply invest in commodities. But of course this can be very risky. A deep global recession is likely to send commodity prices plummeting, but given years of under-investment in new capacity,  such falls could be temporary. Plus the growth of emerging economies such as China is likely to see demand for most commodity groups grow strongly over the coming years.

But as some see it, investing in commodities is essentially a bet against human ingenuity. High commodity prices are often the best cure to high commodity prices as people pour in investment into new capacity, ration use of expensive commodities or find substitutes and eventually the commodity cycle turns as production exceeds demand. In effect people and companies adapt, but of course this takes time.

Among the general commodity funds there’s the ETFS All Commodities sterling ETF and the RBS Market Access Jim Rogers International Commodity Index ETF. There are also a number of ETFs that invest in groups of commodities such as energy or grains and individual commodities such as oil or gold.

Managed funds, most of which invest in the shares of commodity companies rather than the commodity itself, include First State Global Resources fund, JPMorgan Natural Resources, BlackRock's World Mining fund, Allianz RCM Global Agricultural Trends and Sarasin's AgriSar fund.

Then lastly there’s gold, often considered a bet against humanity itself! Gold is often associated with being the ultimate inflation hedge as over very long periods of time it has held its purchasing power. But where it really comes into its own is during periods of heightened investor fears, such as during wars or economic crises hence the bet against humanity remark. Though many experts expect gold to carry on rising, especially as central banks are expected to create more money in a bid to stimulate the economy, it is at risk of hefty falls as prices have come a long way already and it is held by many speculators. Any sign that the world economy is returning to some form of normalcy would probably see gold prices fall back heavily.

There are numerous ways of investing in gold from buying gold coins such as sovereigns and Krugerands through to stock market listed funds such as ETFS Gold sterling ETF and ETFS Physical Gold Sterling ETF. Among funds, which invest in the shares of gold mining companies there’s BlackRock Gold & General and others.

This article reflects the author's opinions and is meant as information only. For investment advice to suit your own needs, always consult a licensed, qualified investment advisor in your jurisdiction.

I hold shares in National Grid and units in the M&G UK Inflation Linked Corporate Bond Fund and the Newton Global Higher Income Fund.


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