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Sharp shifts in interest rates, living costs, and household expenditure dominate the news – but what does inflation mean for investors, and what can we do to prepare for the months ahead?

The important factor is to understand both the advantages and pitfalls of an inflationary economy and use that knowledge to inform your wealth management strategy – with your long-term aspirations in mind.

Volatility and uncertainty are concerning, but the positive aspect is that trading markets inevitably stabilise over time (one of Bob Farrell’s famous ten market rules).

The Recent History of Inflation and Interest Rates

Interest rate rises in the UK owe to a change in the Bank of England (BoE) base rate from 0.1% to 0.25% in December 2021, to 0.5% in February 2022, and 0.75% in March 2022. The BoE will continue to bump up the base rate until inflation reverses to the governmental 2% target.

UK inflation is currently at 7% for the year to March 2022, which is also the highest 12-month inflation rate since the Office for National Statistics began collating metrics in January 1997.

This situation is replicated around the globe – US inflation hit 8.5% in the same month, the biggest jump in 40 years. In Europe, annual inflation (across the EU) is currently at 7.8% – although that varies from 15.6% in Lithuania to just 4.5% in Malta.

There are multiple drivers behind this worldwide transition:

  • Economic downturns as a result of the COVID-19 pandemic.
  • High demand for goods, coupled with labour and material shortages.
  • Increases in taxation and social security contribution rates.
  • The Russian invasion of Ukraine, causing further increases in energy and food prices.

Theoretically, increasing interest rates should slow the economy back down, encouraging more people to save and impacting spending behaviours.

How Does Inflation Affect Investment Portfolios?

Amid this ever-changing climate, the importance of a diversified, well-managed portfolio has never been greater, and it’s a good opportunity to revisit our guide to Risk-Assessing Your Wealth Management Strategy.

The question we’re being asked most at Chase Buchanan is:

  • Whether it’s necessary to reposition portfolio assets to reflect the inflationary environment, or
  • Whether it’s better to leave investments as they are and wait to see what the markets do longer-term?

Much depends on how long inflation lasts and whether it continues to rise.

Inflation can be seen as a stealth threat, chipping away at savings, eroding their real-world value, and putting a dent in returns. It poses a risk because returns aren’t keeping pace with a static picture but need to outpace inflation before reflecting a gain.

For example, if a portfolio asset represents a 2% return before inflation, it would, in effect, produce a negative return of -1% if inflation were at a 3% rate. It can, therefore, be wise to maintain allocations within assets that form a natural hedge, providing a cushion against any spikes that negatively affect other funds.

Our advice is to consult your financial adviser or arrange a convenient time to chat with the Chase Buchanan team if you are concerned. In some scenarios, and particularly in longer-term portfolios, the best advice may be to let the economic turbulence run its course since there isn’t a universal solution that will be appropriate for every investor.

Balancing Short-Term Volatility Against Long-Term Gains

The rule of thumb is that any new investments purchased during an inflationary period should offer returns that are at least equal to inflation.

Just as rising living costs and interest rates mean that fixed salaries represent a real-time pay cut, an investment that makes gains below inflation is losing value. Inaction might be favourable, as investors who jump too soon could forfeit assets with strong future profitability, even if they perform less well in the next 12 months.

The BoE, while noting that it has already adjusted its forecasts for 2022, has stated that it anticipates inflation in the UK reaching 8% this spring and falling back over the subsequent two years. Therefore, if your crystallisation event or expected withdrawals from your portfolio fall after 2024, it may not be advisable to make any sudden changes.

However, the second increase in the energy price cap is due in October 2022, so it’s unlikely that the economy will revert in the immediate future.

Where the investment climate is in a period of constant flux, the most important things to do are revisit the core fundamentals of maintaining a secure portfolio:

  • Focus on strong diversification between asset classes, jurisdictions, companies and sectors.
  • Regular analysis of returns, forecasts and performance to rebalance assets that constitute a risk outside your accepted tolerance.
  • Ensuring investment decisions align with your overall objectives.

We’d also recommend checking that investments or savings products benefit from consumer protection – we cover this in more detail in our article, Global Consumer Protection Schemes Explained.

Understanding Investment Classes and Inflation

It’s impossible to know how the global economy will adapt, but we can draw on experience and economic history to make some assumptions.

Inflation is normally most problematic with fixed-rate securities since interest rate payments and capital repayments will become devalued since they won’t adjust along with inflation. Several assets tend to perform well, notably those that meet growing demand or rise in value along with inflation, such as real estate or energy investments.

When inflation increases, a commodity such as gold is also in high demand since a tangible asset normally appreciates, whether bought directly or indirectly through a mutual fund or ETF. Still, the key is to ensure you spread the risk as much as possible, preserve portfolio value, and avoid overweighting in asset classes that seem beneficial now but may not in a couple of years.

For more information about how inflation and interest rates affect specific investments, to schedule a portfolio review, or arrange a convenient time to discuss any of these topics with one of our advisers, please contact Chase Buchanan.

While we’ve explored inflation and interest rates in general terms, the best course of action will be tailored to your wealth, circumstances and appetite for risk, so professional support is always the optimal solution to make informed, knowledgeable decisions.