Inflation

Today I'm going to talk a bit about inflation. I was recently asked whether I thought investing in gold is a good hedge against inflation. In short, my answer is "yes, but I think there are better alternatives". I'll try to cover as many alternative approaches as I can here, and work out roughly what return an investor might expect, and what risks they might run. As with everything on this blog, this is all my own opinion, it's not intended as investment advice, and you should use it at your own risk.

In my examples I'm going to work out the expected return for a taxpayer paying tax at 20%, assuming two different rates of inflation: 3% (which is pretty much what I expect) and 8% (as a reasonably plausible worst-case scenario).

Physical cash
I'll start with an option which is almost certainly not smart: holding physical cash. Under the mattress for instance. You earn no interest, but there are no associated costs. Every £1 of your money will still be there in 10 years time, but inflation will have reduced its purchasing power. Assuming 3% inflation per year, your £1 will only be worth 74p in real terms. Your annual real return (i.e. after inflation) using this method is minus RPI.

Expected real return: (0 - RPI) e.g. -3% / -8%
Risk: moderate (theft, fire)
Flexibility: very high

UK-based Savings account
The best-buy savings accounts tend to pay an interest rate roughly equal to the Bank of England base rate. If you put your money in a UK-based savings account, and switch accounts regularly to take advantage of the best rate, you can probably earn a return roughly equal to the base rate.

But would that be more or less than the rate of inflation? In normal circumstances you would expect the BoE base rate to exceed the rate of inflation. Most people would rather consume goods today, rather than next year. The rate of interest is the reward for delaying consumption. If the rate of interest is lower than the rate of inflation, then in real terms the interest rate is negative - people are being penalized for delaying consumption. That might prevail for a period, but over the long run you would expect the real interest rate to be positive. In recent times the real interest rate has been approximately 2%.

Tax muddies the water here. If the rate of inflation is 8%, the base rate is 10% (and you earn this in a savings account), then your real return is +2%. But if you pay tax at 20%, then your real return is zero.

Expected real return: ((BaseRate * (1 - TaxRate)) - RPI) e.g. 1% / 0%.
Risk: Low. zero capital risk (assuming you spread your money around enough to benefit from the government savings guarantee) but you run the risk that the BaseRate may fall below RPI, or that banks may pay less than the BaseRate on their savings.
Flexibility: very high

UK gilts
Buying government gilts gives you an almost identical return to a UK savings account. If you stick to short-dated gilts there is minimal price risk, and it removes the risk that you might not find a savings account paying the BoE base risk. On the other hand, buying and selling is slightly harder than just withdrawing cash from your account.

Expected real return: ((BaseRate * (1 - TaxRate)) - RPI) e.g. 1% / 0%.
Risk: Zero.
Flexibility: High

NS&I savings bond
National Savings and Investments offer a 3-year and 5-year index linked savings bond, paying (RPI + 1)% - and it is tax free.

Expected real return: 1% in all circumstances e.g. 1% / 1%
Risk: Zero (guaranteed by government)
Flexibility: Low. Your cash is tied up for at least 3 years.

Gold
Gold is an interesting case. Over the very long term you would expect it to track inflation, but over the short run the price is extremely volatile. There are also costs associated with it - holding physical gold involves significant dealing costs, and even holding it through an Exchange Traded Fund will usually incur an annual charge of 0.4%. Capital gains are also subject to tax unless you hold physical gold that is legal tender in the UK (e.g. gold sovereigns).

Expected real return: (0 - fees - tax) e.g. -0.4% / -0.4% (assuming you keep below the threshold for paying capital gains tax and hold it through an ETF.
Risk: High. The gold price is extremely volatile.
Flexibility: High. If you hold through an ETF you can sell some of your shares at any time to realise cash.

Sterling corporate bonds
Corporate bonds will typically pay a rate of return higher than the BoE base rate. An investment grade corporate bond might pay around 1% more than base rate. The tax situation and overall return is similar to that of a savings account, but there is greater risk (companies can default on their debts, although if you hold high-quality bonds that is extremely rare - Lehman Brothers is the only recent example that springs to mind). There is also greater volatility if you hold longer-dated bonds, since these will fluctuate according to economic circumstances.

Expected real return: (((BaseRate + 1) * (1 - TaxRate)) - RPI) e.g. 1.8% / 0.8%.
Risk: Moderate. Your capital is at risk (albeit quite a low risk) and there can be short-term fluctuation in bond prices. There is also the risk that bond yields may fall below inflation.
Flexibility: High. You can sell your bonds at any time.

Foreign currency savings, gilts, bonds
I'm not going to cover all of these in any great detail. Anything denominated in a foreign currency brings the serious disadvantage of currency risk. Theoretically, over the long term, exchange rates should be determined by the relative rates of inflation in two countries. Therefore, If inflation in the UK is 8%, and the rate in the US is 3%, then in one year the pound should fall by 5% against the dollar. However, investing your money in the US should earn you a lower rate of interest, since you would expect the interest rate to be 5% lower in the US. So in theory these should cancel out, and you will be no better or worse off investing abroad. In practice, however, exchange rates fluctuate far more than this, and therefore you are exposing yourself to substantial currency risk for (in theory) no greater rate of return.

Expected real rate of return: identical to similar UK investment.
Risk: High. Exchange rates can be very volatile.
Flexibility: High.

Inflation-linked annuity
If you are at or close to retirement age, an annuity might be a sensible choice. Current inflation-linked annuity rates for a couple aged 65, with the payout to the surviving spouse reduced to two-thirds after the first spouse dies, are about 2.9%. You would then have to pay tax on that income, so that would equate to about 2.3%. You can try out other numbers here: http://www.fsa.gov.uk/tables/bespoke/Annuities.

Expected real rate of return: n/a since capital is used up, but pays a post-tax income of ~2.3%.
Risk: Low.
Flexibility: Zero.

Shares
Finally, lets get onto shares. To predict the return from shares you have to make a lot of assumptions, but here goes:

• Let's assume that publicly listed companies form a roughly static percentage of the total economy.
• Let's assume that profit margins at publicly listed companies are roughly static.
• Let's assume that new capital investment in the stock market is negligible compared to the total market size (bit of a stretch).
• Let's assume that the UK stock market is a reflection purely of the UK economy (this is simply wrong, because it is very diversified internationally).

At the moment you can earn a dividend yield of about 3.5% on the FTSE100. If the assumptions above hold true, then the earnings of the FTSE100 should increase at a rate of (inflation + GDP growth)%. The real rate of return to the shareholder is therefore GDP-growth + dividend-yield - tax. There is no dividend tax for a basic rate taxpayer, and provided you keep below the capital gains threshold, your return is therefore GDP-growth + dividend-yield.

Expected real rate of return: GDP-growth + dividend-yield, e.g. 6% / 6% (assuming 2.5% GDP growth)
Risk: High. Share prices are very volatile.
Flexibility: High. You can cash in shares at any time.

Summary
There are clearly a lot of choices here, and different options suit different people, but in my opinion there are some options that are inferior in every respect. I rate gold as one of these, and can see no circumstances in which it would be preferable to hold gold rather than an NS&I Savings Bond (unless you are speculating rather than investing).

The investments I rate as worthwhile are:

• UK savings account, for maximum flexibility while still roughly keeping pace with inflation. If banks stop offering such generous rates you could switch into short-dated gilts.
• NS&I Savings bond, for a guaranteed above-inflation return, with no risk and no tax, at the expense of flexibility.
• Inflation-linked annuity, if you are of retirement age, cannot afford the risk associated with shares, and are willing to sacrifice capital for an inflation-linked income.
• Shares, if you can afford to tie up your funds for the long term (at least 5 years) and have the temperament to ride out the volatility.