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FACING THE CHALLENGE
Andrew Fort B.A. (Econ.) CFPcm Chartered MCSI APFS, Certified and Chartered Financial Planner, Fort Financial Planning
The Bank of England has just announced an increase of 0.5% to the base rate, the biggest interest rate rise since 1995. Similar policies have been adopted by the US Federal Reserve as well as the European Central Bank.
In May, the Bank of England predicted that inflation, currently around 9%, would be as high as 11% by the end of the year. That forecast has now been raised to 13.3%. A severe recession is expected. Clearly we live in challenging times. How should investors react?
When the cost of borrowing increases so do interest rates for savers. Not surprisingly, banks (because they put their own interests first) have always been quicker to increase the rate they charge to borrow than they do the rate that they pay to savers. If inflation reaches 13%, and savings accounts only pay 2%* the purchasing power of savings is reduced significantly.
A sound investment strategy looks to the long-term. It also looks backwards in time to see what type of assets actually succeed in delivering a real return in excess of inflation. Such an analysis concludes that depositing cash in an interest-bearing account only rarely achieves a return in excess of inflation. If such interest is then taxed, inflation-beating returns have not happened.
Lending money to governments, often known as bond or gilt investing, exposes the investor to additional risk. The money is usually tied up for a period of time and, occasionally, governments default. Because of the extra risk, investors demand a better return. Over a longer period of time, this type of investing has frequently produced inflation-beating returns, albeit only modestly.
Being an owner of shares, rather than being a lender, has delivered returns comfortably in excess of inflation. Again, risk and reward are related as otherwise nobody with any common sense would take the extra risk if there wasn’t at least a possibility of a greater return.
So, how should investors react? They should make sure that they have enough money in cash for known expenditure in the next two years. Assets that are not needed for 3–5 years could be invested in bonds or gilts, in the hope that most of the time returns might match inflation. Anything else should be invested in portfolios that include shares to provide longterm protection against inflation.
One little reported fact in the Bank of England statement was the hope that inflation would fall back to 3% by the end of 2023 and back to 2% by the end of 2024. Let us all hope that this proves to be an accurate prediction.
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* At the time of writing there are no instant access accounts offering interest above 1.56% (source: moneyfacts.co.uk)
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