How do you improve your wealth creation capabilities in a high inflation economy? Where and how do you invest your hard-earned money? If you have money to save or invest, how can you find a return that is higher than inflation?
In January the inflation rate, as measured by the Consumer Price Index (CPI), fell to 4.2% from 4.8%. The Bank of England is predicting this rate will fall below its 2% target by the end of 2012.
However, the Bank has been making a similar forecast for the last three years and it has not managed to get inflation down yet. In the meantime, the Bank’s main interest rate remains at its historic low of just 0.5%.
There are now some experts who predict that interest rates will remain low for another year or two and that rates may then rise only slightly, perhaps to 1%. And no-one is expecting interest rates to rise significantly thereafter for some years.
This is not good news for people relying on their savings to provide an income in retirement or to supplement their earnings.
So, as savers, how should you prepare for a period when real returns on cash deposits in a bank or building society are well below the rate of inflation?
#1]. Cash Investments
The government national savings organisation NS&I withdrew its index-linked savings certificates some time ago. There are now just three providers offering accounts with returns in excess of inflation, as measured by the older Retail Price Index (RPI) of 4.8%. These are cash accounts with the capital tied up for a typical five years and a rate of return linked to inflation.
If you actually look at these accounts, only non-taxpayers are guaranteed a return above inflation, as tax will erode the returns for everyone else too well below inflation.
In addition, your money will be locked away for a time, and there is no provision for taking an income during that period. So in reality, even with falling inflation, it will still be very hard to get returns above inflation from such cash deposit accounts this year.
#2]. Index-linked Gilts
Index-linked gilts are government-issued bonds – glorified IOUs – that you can buy to obtain a guaranteed rate of return over inflation. They were the place to be during 2011, with some funds that invest in them providing returns of well over 10%.
This is not the norm for these investments and it happened as savers piled into index-linked gilts to shelter themselves from inflation and for safety as concerns over the Eurozone rose.
If you are buying these gilts now, you will be buying them at a premium and it is highly likely that you will suffer capital losses as their value falls back, even while your income remains above inflation.
However, if you are less worried about preserving your capital and require inflation-linked income, then these can still be useful in a portfolio.
#3]. Conventional Gilts
Conventional gilts issued by the UK government offer a fixed income, rather than one that goes up or down with inflation. Investors have continued to invest in them as a safe haven and so have pushed up their prices.
The result has been that the available return, or yield, on buying them has fallen. The yields are now approaching 2% and there are some predictions that they may even fall below this level.
This is a real possibility if bank interest rates remain at current levels. I would be very wary of investing in conventional gilts right now as there is the potential for capital losses as well as low-income returns.
#4]. Corporate Bonds
Companies, not just governments, sell IOUs to investors. They have been a good investment over the past few years a few of the companies issuing them have gone bust, and interest rates on corporate bonds have been well above short-term interest rates.
There are still some decent funds available that let you invest in a fund of these bonds. But there is an increased risk now, with the economic downturn and an increase in the number of companies going into administration.
As investors, you should look at the risk as well as the return. The best “investment grade” bonds are now yielding below 4% per annum while higher-yield bonds, paying 5% or even more, now carry an increased risk of default.
There is also a risk that if interest rates do rise, then the capital values of these bonds will fall. So it is not an ideal time to invest in bonds at present. They are worth a consideration but are not without risk.
#5]. Property Funds
Another conventional class of investments is property. Funds that invest in property actually provide a fair value at present, as property values have fallen steeply over the past four years. You can buy property funds with rental yields of about 3.5-4.5% plus a reasonable chance of some capital appreciation over the longer term.
The combined returns should keep pace with inflation and may even outstrip it, as property does tend to provide returns in excess of inflation over the longer term. These are well worth a consideration, especially as many are now less risky than funds invested in the FTSE 100 share index.
#6]. Equity Funds
In my view, equities – shares in companies – probably provide the greatest potential for income that can beat inflation over the medium to long-term. Dividend yields on many equity funds are currently in excess of 3-4% per annum, plus there is a good chance for capital values recovering as the Western economies pick up.
The corporate world’s finances are in fact in a much better shape than those of governments. Unless we go into a protracted period of economic recession, most businesses are well placed to continue to pay decent levels of dividends. In fact, equity income funds have seen a steady flow of capital into them over the last few months as investors have seen the attractive dividend yields on offer.
So, in conclusion, I see the most value in equities and property at present, as both have the potential to provide above-inflation returns over the longer term. Gilts and bonds have been a good home but now carry an increased risk. Cash has never been able to keep pace with inflation – the last 10 years were an exception.
Finally, do not forget the good old adage about not putting all your eggs in one basket. Diversify, only take risk which you can afford, and invest for the long term.
Article originally posted on BBC Money Talk by Anna Sofat
Director, Addidi Wealth