Who’s Afraid of The ‘Big I’?


Who is afraid? – Starting close to home: a group of UK retirees in Bali using their UK state pensions to fund their twilight years!

Who else?

–  Any retiree anywhere on a fixed pension or annuity

–  People with small incomes

–  Owners of government or corporate bonds

–  People holding large cash deposits

–  Stock market investors

 

So what exactly is this terrifying ‘Big I’?

The ‘I’ stands for Inflation and it caused a brief shock to stock markets this past month. In fact it was an overreaction to a fairly small but sufficiently significant Consumer Price Index reading. Markets reacted negatively as inflation means higher interest rates which in turn discourage borrowing and investing, causing economic growth to slow down.

 

But how does Inflation affect the various groups above?

–  Starting with the UK retirees in Bali, many of them live partly or entirely on UK state pensions earned by their contributions to a state scheme during their working lives. Normally, a person who has contributed the required minimum number of years will enjoy a full pension that is increased every year by 2.5% or the actual rate of inflation, whichever is the higher. But due to a particular quirk of British law those who live in certain countries, including Indonesia, do not qualify for the annual uprating; their pensions are ‘frozen’. So an elderly pensioner will still be receiving the pension he originally received 20 or 30 years ago, just a fraction of what it would normally be today. So news of an increase in inflation is very bad news for these pensioners.

Any pensioner anywhere on a fixed pension or annuity. For this group the impact is the same as that of the ‘frozen’ pensioners in Bali. Annuities provide a degree of security as they are paid for a lifetime, but as they are ‘fixed’ their purchasing value falls over the years with inflation. It is possible to buy inflation-linked annuities but their starting payments will be considerably lower to cover the future cost.

–  People with small incomes. Applying a percentage increase in wages across the board might sound a fair way to compensate workers for rises in the cost of living. But in reality, only the higher paid will effectively be cushioned from the impact. For example, let’s say an increase of 2.5% is awarded. Someone earning $10,000 a month will receive an additional $250 a month. Enough to cope with the higher price of even large items, like a car. But the worker earning $1,000 a month will receive only another $25 a month. Enough maybe to cover the increased cost of basic essentials but more expensive items will be pushed beyond reach. It is strange that society hasn’t cottoned on to this, but conventional across-the-board percentage increases simply widen the gap between rich and poor.

–  Owners of government or corporate bonds. Bonds are considered a relatively safe investment, and historically have attracted a lot of investment funds when financial markets are in turmoil. But while they will normally act as a refuge from falling stock markets they are also subject to losses when inflation strikes. This is because they pay a fixed rate of interest so if general interest rates rise their capital value falls since investors will favour new bonds paying higher rates. Hence, existing bond values fall so that their actual ‘yield’ matches that of newer bonds. Conversely, bond values will rise if interest rates fall. But inflation is the enemy of bond holders.

–  People holding large cash deposits. Many people who are nervous or not ready to invest in property or the financial markets hold large cash deposits in the banks. For the short term, this is generally a ‘safe’ option, even if the interest rate is zero or even negative in some European countries. But the longer the cash remains in the bank it is losing purchasing power. No different from keeping your cash under the mattress except that the mice won’t eat it in the bank. So the higher the inflation rate the faster your wealth will be ebbing.

–  Stock Market investors. The present low-interest environment strongly favours stocks since their dividends plus capital growth make them much more attractive than bonds or other investment options. Access to cheap money is another factor. The past couple of years have been very rewarding to most stock market investors, particularly those investing in US markets, especially the high tech. end of the market. And this in spite of the ravages of the pandemic. But inflation could stop the party, certainly for a while, but stocks will still win over cash in the long term as companies profit from the higher prices of their goods once wages catch up and people are keen to spend again.

 

What can we do in reduce the impact of inflation?

For many, such as those living on annuities or ‘frozen’ pensions, the choices are limited. All one can do is budget for likely price rises and make appropriate adjustments.

Inflation can affect property prices also, so can actually be to the benefit of property owners. Certainly in the long term, although prices can be impacted more by supply and demand which will vary from country to country and even within a country. Having your own property to live in is a great advantage as you will not be subjected to inflationary rent increases but investment property, while potentially profitable, is a far riskier area.

At the moment the short term panic of a few weeks ago has subsided and calm has returned to the markets. But the impact of Covid-19 and the huge relief measures applied by governments, coupled with the almost universal optimism of a return to normality will invariably lead to a rise in inflation at some point. For those investing to build wealth or their pensions this is an opportune time to review investment strategy. Space does not allow for more detail here but the strategy might include moving a degree from the asset classes that have boomed during the pandemic into more ‘defensive’ assets such as infrastructure, inflation-linked bonds, value stocks, gold and commodities. The latter could be particularly interesting. For a decade, commodities were not strong performers but the nascent recovery is starting to highlight serious shortages in some commodities which could rise sharply in price as demand outstrips supply. Spreading the risk is as important as ever and it is best to leave asset allocation to the experts rather than a do-it-yourself approach. Multi-asset managed funds are already making these adjustments.

The current consensus is that despite the recent inflation scare, the party will continue for the time being. You don’t want to miss the party (as some investors did, believing the party was over as long as a couple of years ago) but at the same time you need to be reasonably positioned to face the inevitable day when the party, like all parties, comes to an end!

 

Colin Bloodworth, Chartered Member of the Chartered Institute for Securities and Investment (UK), has spent over 20 years in Indonesia. He is based in Jakarta but visits Bali regularly in normal times! If you have any questions on this article or related topics or would like to receive a free monthly newsletter on financial matters you can contact him at colin.bloodworth@ppi-advisory.com

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