Why inflation-linked investments could damage long-term returns

Investing and pensions

Updated on 24 May 2017 | 0 Comments

Expert warns focusing too heavily on inflation-linked assets could halve returns over the next 45 years.

UK inflation has been rising steadily since November and hit 2.7% in April, overshooting the Bank of England’s 2% target for the third month in a row.

But Sebastian Mackay, multi-asset fund manager at Invesco Perpetual has warned financial advisers that they shouldn’t necessarily be recommending inflation-linked assets to clients in order to guard against therising cost of living.

Mackay explained that real interest rates on investments – after inflation is taken into account – is actually at -1.5% on average in the UK and he warned focusing on inflation-proofing investments by just buying inflation-linked bonds in 2017 could halve the value of a portfolio over the next 45 years.

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How inflation impacts savings and investments

Inflation measures how prices for everyday goods and services are changing and the impact that will have on the purchasing power of our money.

Sustained high inflation means money effectively loses value as time passes. So when it comes to investing funds to use in the future, inflation-proofing is understandably a major focus.

And with UK inflation expected to reach 3.4% by the end of the year, savers will be all-too-aware of the need to ensure investments are keeping pace with rising prices.

For those storing cash in savings accounts, it’s currently impossible to beat inflation with traditional deals on offer from banks and building societies. Typically those that are willing to take more risk with their money and invest have a better chance of beating inflation.

However, as investing is a long-term strategy, investing solely in products that only beat inflation could be a bad move. That’s because only focusing on inflation means you are limiting returns when you could be diversifying a portfolio to bring in much higher yields long term.

Playing it safe could cost you

 Speaking at an FT conference in London yesterday, Mackay commented: “I think it is important to mention that, since the financial crisis, there has been a lot of risk and alarm about hyper-inflation.

“I think that is a non-credible risk. In a world where Governments are keeping inflation round about target or below target, that will erode the value of savings, but it will mean Governments won’t have to take such drastic reaction that we are looking at hyperinflation.

“The need to do that very safe protecting against inflation by buying direct inflation-linked assets isn’t there.”

Hyperinflation occurs when inflation rises rapidly and spirals out of control. In the 20th century it has hit numerous times in countries like Germany and China.

However, even with inflation expected to climb to 3.4%, seasoned loveMONEY readers will know the UK has experienced far worse.

Over the last 10 years inflation peaked at 5.2% in September 2008 and September 2011 (and of course we experienced double-digit inflation in the 70s and 80s).

Better ways to invest long term

Mackay told advisers gathered at the FT conference: “You need to do something more creative.

 “We would favour investing in a Libor (London Interbank Offered Rate) plus benchmark that has a similar return to the equity/risk premium that should at least cover the inflation risk that is currently inherent.”

Jean Medecin, a member of investment committee Carmignac who was also speaking at the event, said it was important to understand where inflation is coming from to beat it.

He commented: “The first thing I would say is in the UK we have a pick-up in inflation but this is very much driven by the weakness of the currency.

“We have this currency issue and the best way to manage it is to manage it with active currency management in your portfolio because when you are buying a gadget today just because it is 20% more expensive in sterling does not mean it is 20% more expensive overall to produce in the world.”

Take control of your retirement strategy with a SIPP

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