Inflation and your investments

To understand how inflation, disinflation and in turn deflation could affect investments, it is only sensible to first understand what these terms, thrown around by the media, actually mean.

Inflation is a widely-recognised trend of increasing prices from one year to the next. It also represents the rate at which the real value of an investment is eroded and the loss in spending power over time. In 1987 £1 would buy you five Mars bars, costing just 20p each*. Now, you can only buy  1.6 Mars bars, meaning that your £1 has less “spending power”.

Inflation can be used by investors to tell exactly how much of a return their investments need to make to maintain their standard of living.

Deflation happens when a country experiences decreasing prices. It is the complete opposite to inflation, but should not be confused with disinflation, which is simply a slowing of inflation.

Deflation can be a good thing. Food prices, which have been pushed down by a supermarket price war, fell by 1.9%, the biggest drop since June 2002, which is good for consumers.**

You might think that people would like to see prices go down. Everything would become cheaper, and the money we have would appear to go a little further than it used to. Imagine how many more of those Mars bars you could buy! However, when this persists, company profits inevitably get hit, and begin to decline. This may force them to sell products at an even cheaper price, and subsequently cut back on production costs. There may then be a reduction in employee wages, and more redundancies, causing an increase in unemployment.

The prices of equities begins to fall as, investors start to sell, due to falling returns and bonds temporarily become more attractive. This is the case until the government can find a way to increase consumer and business spending, for example, by lowering interest rates.

Thankfully, there is no need to panic, as deflation could be a long way off. Just four months before the general election, the government has said that this fall in inflation is “good news for consumers, boosting their spending power after years of weak wage growth”**. We should enjoy, but not too smugly, the current good luck combined with the booming growth and (potentially) falling prices. The deflation that is taking hold in the eurozone, where falling prices have sparked fears of a Japan-style economic stagnation, is due to weak economies. Whilst the International Monetary Fund (IMF) does expect the recovery to continue, it is not expecting a strong growth. Let's hope that both this government, and the next if there's a change, promote the former and positively battle against the latter.

Lower inflation is predominately being driven by the collapse in oil prices which is driving down the cost of petrol, energy and food. Investors may wish to consider how this will impact their portfolios. Here are three fund examples.

Woodford Equity Income

The current disinflation is being primarily driven by lower oil and commodity prices. Mining and oil stocks which have exposure to these commodities have suffered greatly as a result. The Woodford Equity Income fund has very little direct exposure to these areas and has beaten its index over the past six months as a result. If commodity prices remain depressed, or go lower, expect this fund to continue to outperform. Other equity funds which have very little exposure to oil and gas include Fundsmith Equity, Evenlode Income and CF Lindsell Train Equity.

Guinness Global Energy

If you believe oil prices have now bottomed you might want to consider the Guinness Global Energy fund. The fund invests in public-listed equities engaged in the exploration, production and distribution of oil, gas and other forms of energy. The fund lost 28.71%*** in past six months as oil prices collapsed but it is one way to invest if you believe the oil price will recover quickly.

Kames Investment Grade Bond and Jupiter Strategic Bond Fund

Lower inflation means central banks are more likely to cut interest rates to stimulate demand, or at least delay raising them. That's good news for bonds, particularly those with longer maturities. Lower interest rates push up the price of bonds. Should interest rates stay lower for longer, expect corporate bond funds to do well. However, investors should be aware that interest rates are now so low that there is a real danger that bonds could suffer a heavy capital loss if the market is proved wrong and interest rates rise suddenly. The current fall in inflation is being artificially driven by a fall in oil prices and should wages start to rise this year (wage inflation), inflation expectations may change rapidly. For this reason we currently prefer strategic bond funds which are more flexible and can react more quickly to circumstances as they change.

If you would like to make any changes to your portfolio, you can do this by:

*Mathematics of Finance, 21st January 2015
**Reuters, 15th January 2015
***FE Analytics 19th January 2015