The Bank of England this week warned that there are likely to be interest rate rises in the next year and that living standards will be squeezed by slow wage growth and inflation. A squeeze that is likely to be reinforced by the hefty increase to gas and electricity charges.
Inflation looks likely to rise from 2.6 per cent to more than 3 per cent in the coming months. With interest rates at rock-bottom levels — for the time being — this means savers get a very poor real return on their money.
Bond investors are set to suffer similar pain as real yields are squeezed by rising inflation. This leaves shares as the best hope for investors seeking a real post-inflation return.
We outline your options in a world of rising inflation.
Savings accounts
Moneyfacts, the financial research group, has calculated that even the best instant-access account, from Ulster Bank paying 1.25 per cent, is delivering a negative real return (when compared with the rate of inflation) of 1.35 per cent. The best five-year fixed-rate account, from Vanquis Bank at 2.5 per cent, is handing savers a real return of minus 0.1 per cent before the deduction of tax.
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Charlotte Nelson, of Moneyfacts, says: “Negative interest rates are a reality for savers as not a single ordinary deposit account is able to keep up with the pace of inflation.”
Terence Moll, the head of investment strategy at Coutts bank, says: “When the returns on cash are lower than the rate of inflation, the value of cash is eroded in real terms.”
▶Action plan Ms Nelson says that one option would be to put money into a regular savings account paying more than 2.6 per cent, such as First Direct’s Regular Saver for existing customers, which pays 5 per cent. However, there are usually strict conditions, such as a ceiling on the amount that can be invested monthly and a short, usually one-year, fixed term of operation.
Alternatively, you can put money into a current account paying an inflation-beating rate of interest, such as the Tesco bank account offering 3 per cent, although again restrictions apply, including a ceiling of £3,000 on the amount that can earn interest.
Patrick Connolly, of Chase de Vere, the financial adviser, says that the only savings products that are guaranteed to beat inflation are NS&I index-linked savings certificates and these are available only to existing investors. “The best way to beat inflation is to hold growth assets, such as equities, which can perform over the long term.”
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Bonds
Rising inflation is the enemy of bonds, especially government bonds, or gilts, according to Dr Niall O’Connor, the manager of Brooks Macdonald Defensive Capital fund. He says that since conventional bonds have fixed rates of interest they become less attractive when inflation — and interest rates — are rising.
At the same time, inflation will more rapidly erode the real capital value of the bond, so it acts as a double whammy. Mr Connolly says that inflation at 3 per cent would cut the real value of a £100 investment to £86.26 after five years and £74.41 over ten.
“Not a single ordinary deposit account is able to keep up with the pace of inflation
With the bank base rate at an all-time low of 0.25 per cent, government bond yields are also close to a historic low point. Five-year gilts yield about 0.6 per cent and ten-year gilts about 1.3 per cent, so once again investors are receiving a negative real return. Corporate bonds, issued by companies, yield more, but not by much more, and carry greater risk of default. For example, HSBC has an 11-year bond with a yield of 2.5 per cent.
The only way for interest rates to go over the long term is up, and that will be bad news for existing bond holders because when bond yields rise, the price of bonds falls. The bond team at JPMorgan Asset Management estimates that a 1 percentage point rise in interest rates could result in a 17 per cent fall in ten-year government bonds.
▶Action plan If you want to stay with bonds, the JPMorgan team suggests moving from long-dated government bonds to shorter-dated ones, where rising rates will have less effect, or looking at corporate bonds, which yield more than government bonds.
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Mr Connolly suggests looking at index-linked bonds, where the income and maturity values are adjusted in line with inflation. However, since many investors are ready to pay a premium for inflation protection, these bonds already look quite expensive.
Mr Connolly and Dr O’Connor say that holding equities is the best way to be inflation-proof. Dr O’Connor also suggests looking at physical assets such as property or gold.
Shares
Mr Connolly says that shares are viewed as a hedge against inflation because good-quality companies have the potential to increase profits at least in line with prices. He says: “Investors understandably flock to strong and secure companies with consistent earnings that pay annual dividends of about 3.5 per cent. These are the types of stocks that are typically found in equity income funds.”
However, he warns that 80 per cent of all UK dividend income is produced by 15 stocks, so there is likely to be a high crossover between one equity income fund and another. To protect against this he recommends putting some money into overseas income stocks to achieve greater diversification.
Russ Mould of AJ Bell, the investment platform, says that investors should seek stocks that have pricing power and that increase their dividends consistently. “Companies that have pricing power include those with a technological edge, strong brands, a steady flow of predictable revenues or strong market share. There are 27 stocks in the FTSE 100 index that have grown their dividend every year for the past ten years and this has provided not only an inflation-beating income stream, but a strong total return.”
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When it comes to notching up years of unbroken dividend increases the real champions are investment trusts. City of London has 51 years of continuous dividend rises, followed by Bankers, Alliance Trust and Caledonia Investments, all on 50.
▶Action plan Buy stocks and funds that can grow their dividends consistently, diversify your portfolio and look for companies that have pricing power.
The experts’ picks
Patrick Connolly picks two UK income funds — Threadneedle UK Equity Income, yielding 3.8 per cent, and Aviva UK Equity Income, yielding 3.6 per cent. Among overseas funds he goes for Artemis Global Income, which pays 2.7 per cent, and Threadneedle Global Equity Income, with a yield of 3.4 per cent.
For stocks with pricing power Russ Mould selects Apple, Unilever and Halma. “Apple’s phones and tablets are owned by millions of people. Unilever has one of the best portfolios of brands in the world. Halma, the provider of lift safety products and smoke detectors, can use its installed products to generate recurring revenues.” Among dividend-growing stocks he likes Croda, the chemical company.
Mick Gilligan of Killik & Co goes for two investment trusts — Scottish Mortgage and Temple Bar. “Scottish Mortgage holds stocks such as Amazon, Tesla and Facebook, which are well placed to maintain profit margins. Temple Bar holds a portfolio of out-of-favour stocks, which history suggests will ultimately experience a re-rating.”