Soon we’ll not be supporting this browser anymore.
This means our website may not look and work as you would expect. Read more about browsers and how to update them here.

Skip to main content
  • Register
  • Help
  • Contact us

Could an inflation revival change the world of investing?

The Covid-19 pandemic and the way governments have responded to it have got some investors talking about inflation again. We take a closer look at what it could mean for investors and ways to navigate it.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Companies, stock markets and economies around the world have all been hit hard by the pandemic. Jobs have been lost, businesses closed, and economies halted.

With such a devastating impact, governments around the world have had to come in and try to pick up the pieces. In most cases that’s meant ploughing as much money as they can into the economy. This is in the hope that it props up businesses, keeps people in jobs and helps take care of the overall health of the economy.

The main way governments borrow money is through selling government bonds – that means they essentially swap the bonds for cash. But it’s not the only tool in the box. Cutting interest rates, which we’ve seen a lot of recently, is another example. Lower interest rates make it cheaper to borrow money and usually encourages people to spend more.

Seems simple enough? Well, borrowing isn’t always a good thing. It can be tough to balance the books on how much the government borrows and spends with how much it takes in through taxes.

Predictions show that UK borrowing could be as high as £394bn for the current financial year (April 2020 to April 2021). While we might be in exceptional circumstances, there’s no doubt that that’s a lot of money. And there are certainly going to be some long-lasting impacts.

A combination of massive government spending, rising debts, low interest rates and quantitative easing programmes might cause inflation to rise again in the future.

Why does it matter to investors?

Inflation’s a measure of how much prices have gone up over time. It’s the rate cash becomes less valuable – £1 this year will get you further than £1 next year.

Inflation tends to be a good sign in a healthy economy, but too much of it can be hard to reel in and control. That’s why the Bank of England currently has an inflation target of 2%.

While inflation can be good for stock markets – it normally means the economy is growing – too much of it can also be an investor’s nemesis. After all, the higher the level of inflation, the higher your investment returns must be to beat it.

The aim of every investor is to beat inflation – to make your money worth more than what it would’ve been if you hadn’t invested it. If your investment grows 5% over a year and inflation is at 2%, then you’ve beaten inflation and made a “real” return of 3%.

How does inflation work?

It might surprise you to learn how much economists disagree over inflation. What causes it, how it should be controlled and how investors should respond are all bones of contention.

First, let’s look at the major theories of how inflation works, starting with Keynesianism.

John Maynard Keynes argued inflation was caused by an imbalance of supply and demand in the economy. For example, if unemployment falls, businesses have to offer higher wages to attract workers. These workers then have more disposable income and therefore demand more goods and services.

If the economy can’t supply enough to satisfy this demand at current market prices, consumers will bid prices up which causes inflation. When workers see prices rising, they’ll demand higher wages. This again leads to higher prices, and so on.

This theory would predict that low unemployment and high government spending might cause excess demand and therefore inflation. On the other hand, high unemployment and government cuts would cause deflation, or falling prices.

This sounds plausible and intuitive, and seemed to be born out by the data, which shows the relationship between unemployment and inflation over time.

US unemployment and inflation

Source: Federal Reserve Bank of St Louis, 1 November 2020.

However, the events of the 1970s cast doubt on Keynes’ theory of inflation. In the 1970s both unemployment and inflation were high at the same time, appearing to contradict the theory. This was known as stagflation. And despite the reduction in unemployment over the last decade, inflation’s been nowhere to be seen.

Enter the Monetarists.

The Monetarists argued inflation was caused by increases in the quantity of money circulating in the economy. Just like an increase in the supply of a good causes its price to fall, an increase in the supply of money causes its value to fall, which shows up as inflation.

When governments print money to fund spending instead of raising taxes, Monetarists think inflation will eventually follow.

Monetarist ideas were very popular following the stagflation of the 1970s, but recent events have cast doubt on them too. After the Financial Crisis, central banks cut interest rates to historic lows and printed vast amounts of money for quantitative easing programmes. What followed was a massive increase in the supply of money, but inflation has failed to follow.

In response, economists on all sides of the debate have tried to adjust the theories to fit the data, or have turned to new theories like Modern Monetary Theory or the Fiscal Theory of the Price Level.

Today major central banks seem to operate on a broadly Keynesian model. Central bank inflation reports are full of supply and demand measures and forecasts, and money supply measures aren’t given much prominence.

Outside thinkers on inflation

The Bank of England Monetary Policy Report (November 2020)

The Bank of England’s Monetary Policy Committee is currently forecasting low inflation in the near term, followed by an increase back to the 2% level towards the end of 2021. However, they do acknowledge uncertainty is “unusually high”.

The Bank’s projection is based upon an increase in the unemployment rate at the end of the first half of 2021, peaking at 7.75%. As the economy recovers unemployment is forecast to fall and, as Keynes would predict, inflation is to return to target.

If the Bank’s right and inflation returns smoothly to target over the next year, then there’s little to worry about. However, uncertainty is high, and another round of quantitative easing has again increased the money supply.

The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival – Charles Goodhart and Manoj Pradhan

Of course, not everyone agrees with the mainstream view. Goodhart and Pradhan argue in a recent book that “as in the aftermath of many wars, there will be a surge in inflation, quite likely more than 5 per cent, or even on the order of 10 per cent in 2021”.

The argument is essentially one of demographics. As the global population ages, especially in western nations, the ratio of workers to consumers will fall. This will lead to pressure on prices as output fails to keep up with demand. A relative shortage of people able to work will also mean workers can demand higher wages. The result is inflation.

The argument is fundamentally Keynesian as it’s based on an imbalance of supply and demand. However, the authors imply that the pandemic might well be looked at as a turning point in history.

The theory is interesting but sweeping forecasts should usually be taken with a pinch of salt.

How inflation swindles the equity investor – Warren Buffett, 1977

You might initially think inflation shouldn’t be too bad for investors in shares. If inflation takes off, companies can just raise prices and trundle along as though there was little to worry about. However, Warren Buffett argued that this wasn’t the case during the inflation of the 1970s.

UK Stock Market and Inflation 1970-1984

Source: Refinitiv Datastream.

Buffett’s argument was that businesses actually find it very difficult, if not impossible, to increase the returns made on their assets by enough to offset inflation. As you can see in the chart, stock markets only took off once inflation was brought under control at the start of the 1980s.

This is because even if a company can raise prices, operating and capital costs also rise. In theory the effect should be neutral, but in reality businesses find this difficult.

If inflation’s usually bad for stocks, then what kind of investments do make sense?

What inflation means for different investment types

Remember all investments will fall as well as rise in value, so you could get back less than you invest. This article isn’t personal advice. If you're at all unsure, make sure you ask for advice.

Bad news for bonds and cash?

When you buy a bond, you’re lending money to the issuer – usually a company or government. In return for lending them money, they aim to pay you back the face value of the loan at a certain date, and interest along the way.

For most bonds, the amount they pay in income is fixed. Fixed income is great for knowing how much you’ll get from your investment, but not so good if inflation rises above it.

Let’s say you invest in a bond that pays you 2%. If inflation is 3%, then you’re still losing out in real terms. However, while you could be losing some value if inflation’s above the returns on your bonds, it could be better than just leaving it as easy access cash in your bank. You’ll generally get better interest with bonds or fixed-term savings. Losing less is better than losing more.

Remember though, while investing your money could help beat inflation, it’s still important to have some cash on the side for emergencies. You should aim to have an emergency cash fund worth 3-6 months’ of essential expenses when you’re working and 1-3 years’ of expenses when you’re retired.

Should I save or invest?

However, it doesn’t all have to be about losses if inflation hits. It’s possible to invest in inflation-linked bonds, or funds where the manager does it for you. With these types of bonds both the income and the amount you get back at the maturity date rises in line with inflation.

Bonds like these could offer some shelter if inflation does pick up.

Bond prices, inflation-linked or not, have a negative correlation with interest rates – when rates rise bonds will generally fall. It’s the same with most major investment types. And while we don’t think interest rates will rise meaningfully in the short term, it’s a common intervention to try to combat inflation. A risk bond investors should keep in mind.

How could shares fare?

Historically shares have delivered the best long-term returns, but that doesn’t mean they’re immune to inflation eating away at returns.

Companies tend to like a little inflation, but too much becomes a problem.

As Mr Buffett says, companies must make more money on their investments to keep up, all while their costs generally rise. For the investor, higher levels of inflation mean we need greater returns to beat it – a hunt for greater returns usually means accepting more risk.

Investors will want to look for businesses that can pass price increases on to customers. This means strong brands and high-quality businesses with enviable competitive positions. Companies that make strong margins now could be good candidates, as they already demonstrate pricing power.

Companies with lots of fixed debts could see inflation help erode the burden – inflation eats away the value of debt, too. Inflation can also lift the prices of fixed assets. Businesses with these characteristics – what we’d usually call “value” – have been deeply unloved over the last few years. Value as a style of investing might actually benefit if inflation ticks up.

However, all in, inflation isn’t great. 2% should be comfortable. 5% and we could see some of the above effects. But high single digits and above gets very tricky to navigate for investors and companies alike. Remember, shares aren’t immune, and are higher-risk than bonds. Past performance also isn’t a guide to future returns.

How our HL fund managers look ahead for the best returns

What about commodities like gold?

For lots of investors there’s a perception that gold is a good place to be when inflation hits. It’s deemed the obvious inflation hedge, but should it be?

Inflation adjusted value of £1,000 gold investment

Past performance is not a guide to the future. Source: Refinitiv Datastream, 28 November 2020.

Ideally, what we would expect from a perfect inflation hedge would be for the value to remain constant at $1,000. But the data shows that the relationship between gold and inflation isn’t exactly crystal clear. There’ve been times in the past where it’s been useful to offset inflation. But more recently the relationship’s been pretty shaky. A testament past performance isn’t a reliable guide to the future.

In fact, the only time it seems to have offered a clearer hedge to inflation is in the 70s. And that’s when inflation was around 24% – as high as it’s ever been in the UK. When we look past the 70s, the case for investing in gold to combat inflation looks less and less convincing.

However, that doesn’t mean investors should be put off completely.

While it’s unlikely to reach the highs of the 70s, the way precious metals tend to retain their value could add an extra layer of diversification.

Whatever your view on inflation, investors should be cautious. Gold, silver and other commodities are volatile – we think holding anything over 5% of a portfolio is pretty adventurous.

So, what should investors do?

Knowing how much to change your portfolio in response to uncertain or unlikely events is difficult. It’s perfectly reasonable to avoid macro-economic forecasts altogether. And we certainly don’t think investors should upend their strategies or distort their portfolios out of fear.

Whether inflation stays low or rockets to double digits, having lots of different investments in a well-diversified portfolio should stand you in good stead for the long term.

At most, think about making some small changes to align with your own outlook. This doesn’t mean making massive predictions. It’s more about fine tuning your weightings.

Investing in a tax efficient account, like an ISA, is also important as capital gains taxes are assessed on nominal gains. So, if the value of your investment rises by 5% but inflation is also 5%, you must still pay tax on the gain. By investing in an ISA or SIPP you can remove this risk entirely.

Please note tax rules can change and their benefits depend on your circumstances.

If you do think inflation is coming it’s tricky to know where to turn. If you’re all in on shares and bonds, you could consider some commodities, or even infrastructure. Sectors like these can often rally where inflation starts to pick up speed. Just be aware of the extra risks they carry.

Remember no one knows for sure what the future has in store. Any changes you make should be in line with the amount of risk you’re happy taking and shouldn’t take you away from how diversified you are.


READ MORE

Explore our Investment Times winter 2020/21 edition for more articles like this.

See all articles


What did you think of this article?

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Editor's choice – our weekly email

Sign up to receive the week's top investment stories from Hargreaves Lansdown. Including:

  • Latest comment on economies and markets
  • Expert investment research
  • Financial planning tips
Sign up

Related articles

Category: Shares

4 simple steps for researching shares

Lots of investors find researching shares a bit daunting, but if you’ve decided to consider investing in them, you have to start somewhere.

William Miles, Junior Equity Analyst

30 Jul 2021 5 min read

Category: Shares

Shares aren’t a one trick pony

Not all stocks are created equal. Here’s a look at how some shares might be more diverse than you think.

Sophie Lund-Yates, Equity Analyst

30 Jul 2021 7 min read

Category: Investing and saving

New podcast from HL

The ‘Switch Your Money On’ podcast from HL is launching its pilot episode this week, available to stream on Spotify.

27 Jul 2021 1 min read

Category: Investing and saving

Self-employed payments on account deadline – 2 tips to avoid overpaying

The ‘payments on account’ deadline is 31 July. We share strategies to help you save tax with HMRC.

Isabel McDougall, Pensions and Retirement Writer

27 Jul 2021 3 min read