Inflation Matters
David Miller - 29.4.08
After 26 years, inflation has been removed from the calculation of capital gains tax and almost instantaneously 31st March 1982 has joined 5th April 1965 as a date that once had a huge impact on investors and is now no more than an historical footnote. It does, therefore, seem timely to consider the current background to inflation and the implications for investment policy.
UK Retail Price Index 1948 - 2008
Source: Bloomberg
Apart from a brief resurgence in 1988-1990, could inflation be making a comeback after a quarter of a century of good behaviour? Measured by the volume of analysis, one might conclude that the answer is yes, but the evidence accumulating is by no means clear and markets remain in a state of indecision.
Perceptions of inflation vary depending on where you live and what you spend your money on. Rice prices have more than doubled in the last twelve months, private school fees in the UK are up 60% in the last 5 years, but for the major economies, average inflation, as defined by governments, is only 3.3%. Admittedly high relative to the last 10 years but modest none the less.
In emerging markets, it is an entirely different matter. Food, energy and raw materials make up a greater proportion of spending and so in Brazil, India and China inflation is averaging around 8% with frontier economies like Vietnam, Venezuela and Ukraine, to name a few, suffering inflation of 20% plus.
Central banks are concerned about inflation. As predicted in January, the reaction in Europe has been much more cautious than in the US where interest rates have been reduced to 2% and broad money has increased by over $1trillion since last July.
Unfortunately, what seems to be happening is that these supposed remedies for the Western credit crisis are bypassing the intended beneficiaries and instead are inflating the already strong emerging economies. The law of unintended consequences rules yet again.
In the major economies, an inflationary spiral seems unlikely. Normally you need a dangerous cocktail of labour market rigidity, government spending financed by printing money and a block on the free flow of goods to cause real trouble. If anything, rising input prices caused by higher commodity prices are more likely to result in margin erosion and lower corporate profits than inflation. As house prices weaken and concerns about job security rise, it is hard to construct a case for a sustained rise in consumer prices. The optimistic view is that the US recession will slow the emerging economies and call a halt to the rise in raw material prices seen in recent years. If not, then those who believe that visible inflation outside the core markets is the tip of the iceberg will be proved right and the inflation battles fought and won in the early 1980’s with great sacrifice will have to be fought again. We will see Inflation has hardly troubled investors for a generation and, apart from Japan, experience of deflation comes only from the history books. Most investors and their advisers seem to assume that moderate inflation and sound money is the starting point for constructing an investment policy. It is easy to forget that prices generally fell in the UK throughout the eighteenth and nineteenth century and that inflation only became accepted as normal because of the economic impact of two world wars.
Generally it is perceived that inflation was a problem in the 1970’s and has not been an issue since the early 1980’s. Looking at the 25 year periods either side of 1982, this is clearly the case. Up to 1982, prices rose approximately 7 times whereas subsequently, the increase was only 2.5 times. So a much better result and the reason why investors are less sensitive to inflation than in the past.
Take a step back, however, and consider the investment implications of 25 years of tame inflation. Investors would have needed to achieve an annual capital return of 3.7% after paying tax and spending income just to maintain the real value of their capital and by association their spending power. This is the equivalent to a total return for a UK top rate tax payer of over 10% per annum.
The implications for investment are clear whether or not inflation is making a comeback. Minimising tax and saving income will significantly increase the return achieved. In addition, investment policy needs to be directed to achieving a real return even if income security is a priority and this does, of course, involve risk. Settling for lower risk investments like gilts, with an annual return of 5% will, over time, lead to a significant reduction in the real value of both capital and income.
At present, with inflation rising and economic growth slowing, it would be easy to turn away from riskier, more volatile investments such as equities, hedge funds and commodities and retreat into guaranteed return investments with limited upside potential. Unless we are heading for economic disaster and a deflationary recession lasting a number of years, this will prove to be the wrong medium term policy. Even moderate inflation is corrosive and portfolios should be structured to beat inflation, even if income and security are a priority.
It would be ironic if the start of the new, inflation free, capital gains tax regime coincided with a period of higher inflation.
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