Markets

Three scenarios that show how quickly inflation can erode your wealth

Further increases in inflation may lie ahead in 2018 and 2019. In the first of a new series, we highlight how inflation can affect your investments

01/05/2018

David Brett

David Brett

Investment Writer

Investors can underestimate the damaging effect inflation can have on their wealth. Increases in the cost of living reduce the spending power of your money. Over decades the effect can be dramatic.

We demonstrate this below in a chart that shows three scenarios.

For pension savers, the concern is understanding what their savings may be worth at retirement, decades in the future.

The challenge, therefore, is to achieve investment returns that keep ahead of inflation. As the billionaire investor Warren Buffett put it: “Arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislature. The inflation tax has a fantastic ability to simply consume capital.”

Inflation can be good for holders of assets, if their values rise faster than the general level of inflation. This could include houses, commodities such as gold and some shares.

However, it can be bad for anyone with a fixed income: pensioners and for workers with weak wage bargaining power. Inflation is most tangible with everyday goods. It can explain why a Mars bar that cost 26p in 1990 costs 60p today.

While the UK consumer price index (CPI) fell to 2.5% from 2.7% in March, bringing much needed relief to households, investors would be complacent to assume that the threat from high inflation has abated. In the US, the deflation of three years ago is a distant memory. CPI has risen from 2.1% to 2.4% so far this year.

What could cause inflation to rise?

Global inflation has been low in recent years compared to historic norms. In the 1980s it was as high as 14%, and peaked at a little over 10% in the 1990s, according to data from the World Bank. For the last two decades, the norm has been around 4%, apart from a brief period before the global financial crisis. With the global economy still not back to full health, pressure on prices has been weak and inflation fell to as low as 1.5% in 2015.

Very low or very high inflation is damaging to the economy. Central banks are usually tasked with keeping inflation at 2% in order to maintain a stable and healthy economy, or a “Goldilocks Economy” – not too hot, not too cold. They mostly use interest rates to do this, although in the post-financial crisis era they have also deployed more unusual policies, such as programmes of quantitative easing.

Global inflation: 1980-2016

Inflation (%)

 

Source: World Bank

However, greater price pressure may be building. The Schroders Economics Group recently raised its forecasts. It now expects inflation to rise from 2.3% to 2.4% for 2018 followed by an increase to 2.6% next year. For the US, inflation is forecast to rise from 2.1% to 2.6%.

There are currently four main factors for investors to consider:

  1. Higher wage growth - unemployment rates are low in many major economies, so staff may be able to demand bigger pay rises.
  2. US tax cuts – President Donald Trump’s fiscal plans could put more money in the pockets of companies and consumers, fuelling further demand for goods and services.
  3. Rising oil prices - higher oil prices usually mean the cost of making and transporting goods rises, which is passed on to the consumer.
  4. Trade wars - the US and China are threatening to put tariffs on each other's imported goods which will be passed on to the consumer in the form of price hikes.

Read more: Is the road to inflation taking us back to the 1960s?

How inflation is measured

The consumer price index (CPI) is the most popular way to measure inflation. The CPI tracks the price of a basket of everyday goods and services such as groceries from the supermarket or fuel from the petrol station.

How inflation erodes your money

When it comes to your finances inflation can be a silent wealth killer.

The graph below illustrates how the value of £100 in your pocket could have been eroded by the effects of 1%, 2% and 5% inflation over the last 10 years.

In the worst case scenario below, if inflation were to average 5% a year over a 10-year period, your £100 would be worth just £55.

Of course this damage to your wealth can be mitigated. Putting the money into a savings account will earn interest. Investing it has the potential to offer better returns, although your capital is at risk.

 

What next?

Assessing the future level of inflation is notoriously difficult. Analysts look at demand in the economy and try to judge where that economy might be in its economic cycle, the natural fluctuations of the economy as it moves from high growth to slowdown, or even recession.

As ever, focus is on the US. The direction of inflation there will undoubtedly affect the rest of the world.

Keith Wade, Chief Economist at Schroders, said: “Our analysis highlights a pick-up in inflation as being the greatest threat to the US expansion at present. The Fed faces a tricky task in tightening policy without triggering a sharp downturn given the lags from changes in rates to the economy.

“In this cycle the problem could be exacerbated by a fading of fiscal stimulus after 2019. Current plans suggest a fiscal cliff in 2020 as tax cuts and spending increases evaporate around the same time that higher interest rates are having their maximum impact.

“Hence 2020 is our most likely date for the end of the cycle expansion. Arguably those risks are somewhat over the forecast horizon, and indicate that the current expansion is set to become the longest on record, a landmark which will be achieved in July 2019.”

A slump might normally dissipate inflationary pressure but this has not always been the case. Wade highlighted that current trade wars could lead to “stagflation” – when high inflation coincides with a stagnant economy. In this case, it could be that tariffs push up prices and the assault on free trade stalls economic growth.

While professional investors examine near-term outcomes, individual investors can remain focused on the long-term. Many studies have shown equities to be one of the best options for staying ahead of inflation over long periods. The Barclays Equity Gilt Study shows UK equities have returned 5.1% a year over 118 years, compared to 0.7% for cash. That is a “real return” – one that takes into account the impact of inflation.

The next report in this series will focus on how different types of investment perform when high inflation emerges.

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