Inflation now the number one issue for investors

What a difference a year makes. Just 12 months ago we were still in collective back-slapping mode, congratulating ourselves for how well we had done during the pandemic while interest rates and inflation remained at historic lows.

Then everything changed. There were signs of inflation creeping up as 2021 drew to a close and the rumblings from central banks pointed to interest rate rises to counter it. And then Russia invaded Ukraine triggering myriad human and economic consequences including an energy crisis of a magnitude not experienced for half a century.

The impact on financial markets has been unsurprising to say the least. Stock prices have fallen precipitously since the beginning of the year, albeit with some periodic rallies in response to perceived good news, while bond yields and the value of other defensive assets have gone up.

So, what is a personal saver or investor to do? Equity markets are in retreat but putting your money into cash or bonds is a sure way to see the value of your savings erode over time thanks to inflation.

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“For those with significant savings, of which there are many given the savings rate during Covid lockdowns and so on, the practical inflation impact is that the real value of their savings is falling on a yearly basis when inflation is rising,” says Grant Thornton tax partner Oliver O’Connor.

“The general rate of inflation is likely to be in the high single digits for the year and so money that is not invested will have fallen in real value terms by the same percentage over the course of the year.”

He does see a positive side for those who wish to avoid investment markets, however.

“Interest rates are also on the rise, though significantly slower and lower than the inflation rate,” he notes. “If investors are able to take advantage of some of this interest rate rise on some savings at least they are partially mitigating the inflation burden. This is a short-term solution, however, and in order to best protect one’s accumulated savings over the longer term, investment in the markets is key.”

Those rising interest rates are also having a negative impact, according to Ian Quigley, Brewin Dolphin head of investment strategy and financial planning.

“Looking back to 2020, Jerome Powell said the Federal Reserve was not even thinking about raising rates,” he notes.

“The implication was that rates would stay low for several years. We have since experienced what I would describe as an interest rate shock. During 2020 and 2021 they were effectively zero and are now up to 3.75 per cent. That’s a hell of a move and has had a big impact on asset prices.”

The fall in asset prices has been a response to that, he points out.

“Valuations have come down everywhere. Not surprisingly, the most expensive assets have come down the most.”

The inflationary pressure which triggered the rate increases is also having an effect.

“If you look back through history, when inflation is north of 5 per cent, valuations come down,” says Quigley who points to the profit earnings (PE) ratio measure of a company’s value as an indicator.

“In the US market when inflation was around 6 per cent the PE average came down to around 15. When it was between 3 and 5 per cent it was 19. Historically, interest rates and bond yields have gone up. People who have invested in equities this year have seen a decline in value, albeit after three very strong years. But the 10-year market view that we had at the start of the year is still the same. It’s just that the period has started with a fall.”

And that view is for risk assets such as equities to outperform inflation over the period.

Bank of Ireland chief investment strategist Kevin Quinn agrees: “If you look at it over a decade, the evidence is pretty overwhelming that risk assets in a portfolio will beat inflation. Cash will not.”

Inflation is now the number one issue for individuals and investors, he adds, pointing to a recent Bank of Ireland survey where 30 per cent of respondents said inflation was their biggest concern. That compares to 15 per cent who put housing on top.

“If US inflation is turning downwards, the EU rate is pointing upwards,” he says.

“I wouldn’t be surprised if it goes above 10 per cent. The expectation is that it will have moderated to 5.5 per cent by mid next year. That has a big bearing on what people need to do with their savings. It changes what’s available and impacts every single asset class. Cash is guaranteed to lose value in real terms. Bonds are somewhat less straightforward.”

His advice is for people to plan for the longer term.

“Someone with a 5-10 year time horizon is much more likely to overtake inflation in returns. And you need a diversified portfolio. Don’t judge it over a year. It’s not possible to do that. It’s a fool’s errand to try to time the market.”

The broad repricing in assets also presents opportunities for people, according to Quigley. He explains that if a company maintains turnover and profitability and an investor buys its stock at a lower price, they will get a better yield than they would have had the bought in at the higher price which prevailed earlier in the year.

“For those looking at the longer term, it is more attractive to be buying now than it was in January,” says Quigley.

“The base assumption there is that the market system that has been in place for over 100 years persists, and that the world economy gets wealthier, and companies generate increased profits and earnings over time. If that’s wrong, this is wrong, but I don’t believe it is wrong.”

In that case, it might be a good time to heed the advice of Warren Buffet and get greedy when others are fearful. But be ready for a bumpy ride.