A lmost every investor, whether a private individual or a trustee of an endowment or a pension fund, is investing with the long-term need to grow their investment portfolio at a rate above inflation. The key reason inflation is a crucial minimum target is because any lower return will actually destroy the purchasing power of that portfolio over time. In fact, most investors actually need to grow their purchasing power and significantly beat inflation over time. This is because their future liabilities, such as the purchase of a house, university fees or pension obligations for a company, often rise in excess of inflation, and many investors actually desire to improve their wealth, not simply maintain its purchasing power.

The United Kingdom uses two measures to monitor inflation, the Consumer Price Index (CPI) and the Retail Price Index (RPI). CPI is an internationally standardised gauge that measures the change in price of a basket of goods each year. It is designed to measure the changes in the cost of living. (Unlike RPI this index does not include, among other items, mortgage costs and council taxes). Over the past 12 months the CPI index has risen 3.7 per cent

To demonstrate the effects of inflation, if CPI continues to run at 3.7 per cent per annum, a basket of goods which costs GBP1,000 today will cost GBP2,000 in 20 years and GBP3,000 in 30 years. An investment portfolio that does not grow at an equivalent rate will diminish in its purchasing power.

The return of an investment ignoring inflation is called the nominal return and the return after adjusting for inflation is called the real return. For example, an investment that returns 2.7 per cent in nominal terms in an environment where inflation is 3.7 per cent will actually produce a negative real return of -1.0 per cent.

Inflation can also adversely affect the prices of many assets that investors use as blunt instruments to beat inflation. Fixed income investment prices are depressed as interest rates tend to rise as inflation rises. The rationale for this price drop is twofold as market expectations of higher inflation imply a decrease in the real value of bond coupons and/or because central banks generally raise short-term interest rates in an attempt to fight inflation. When interest rates rise, bond prices fall. Thus, inflation may lead to a fall in bond prices impacting many investors’ portfolios.

Inflation can also hurt equity prices. Historically there has been a strong relationship between inflation and the multiple the market puts on earnings from equities. As inflation rises, the P/E (price divided by earnings) multiple of the market tends to fall. Unfortunately for investors who would look to equities to act as a hedge against inflation, the narrowing of P/E multiples has been particularly pronounced in periods when CPI has moved above 6 per cent.

There are two main schools of economists. The first camp, known as Monetarists, say there is a fixed amount of goods and the supply of money determines the price paid for those goods. Another branch of economists called Keynesians and neo-Keynesians believe there are two types of inflation, one stemming from demand pulling inflation higher or from costs pushing inflation higher.

We believe the current environment can be described by Friedman’s ‘liquidity effect’, where an increase in money supply leads to an increase in demand for securities, increasing their price and lowering interest rates. An increase in money supply will have an expansionary effect on real incomes and price levels, which will then tend to lead to increased interest rates. However, in the short-run an increase in the money level will increase expectations of inflation. Higher anticipated inflation will increase nominal interest rates. This ‘price anticipation effect’ could even have a stronger impact than low interest rates, which is consistent with empirical studies of countries with high inflation where interest rates are also the highest.

We believe that investors and trustees now need to consider the risks of inflation over the coming decade more than at any time in the past 25 years.

The effects of zero-interest polices, quantitative easing, the printing of money and rapidly rising energy and food prices are all inflationary forces that need to be dealt with.

Unfortunately, most major Western governments are struggling with massive fiscal deficits and ballooning national debts. If you put yourself in the shoes of a politician it is very easy to understand why inflation will continue to be very sticky on the upside. The UK and the US have put themselves in situations where they have been running double-digit fiscal deficits and their national debt is approaching the level of annual GDP. The US is in a scenario where it is completely incentivised to destroy the purchasing power of its currency to reduce the real value of its debt. Foreigners now own more than 40 per cent of all US treasuries and a plummeting US dollar (USD) is a wealth transfer to the US economy. Any elected official considering cutting costs to reduce the fiscal deficit risks infuriating the people who elected him and will err to the side of inflation.

Over the past decade, the UK M4 (a broad measure of money supply used by Bank of England) has risen from GBP0.8 trillion to GBP2.2 trillion (9.5 per cent per annum growth). Inflation from this rapid increase in money supply has been masked by disinflationary forces coming from China. Outsourcing to emerging markets reduced the cost of goods produced and increased Western productivity dramatically.

We believe the most important thing investors can do today is to position their portfolios against much higher future inflation as the human element will ensure that fiscal deficits, low interest rates and the printing of money will continue to be the preferred route of fiscal and monetary policy. The inflationary effects of this will be the major theme for the coming decade.

Investors have turned to stocks and bonds as a way to build long-term wealth because these asset classes have historically delivered inflation beating returns. Equities have delivered the largest nominal return and largest risk premia versus inflation. The chart opposite shows equities have delivered approximately 5 per cent more than inflation per annum since 1900. The above-average returns have come with much higher volatility than bonds.

Both government bonds and corporate bonds have also beaten inflation, and done it with a lot less volatility. Many cautious investors are drawn to the lower volatility of government bonds. Unfortunately we believe many of these investors are at the greatest risk of losing ground to inflation in the coming years. At the time of writing this article, UK 10 year Gilts are yielding 3.6 per cent, which is less than the most recent annual CPI figure of 3.7 per cent. This clearly shows one of the problems of looking at historic returns to determine asset allocations for portfolios that need to deliver real return for clients to meet their objectives. Given our expectations for the coming inflationary environment and the negative real yield on government bonds from many Western countries, we believe this shows the flaw in statically allocating to traditional asset classes with the hope of generating positive real returns

The investment industry offers investors many types of products, which are benchmarked versus traditional asset classes, such as equities and bonds or combinations of the two. Fund managers often speak with pride that they have beaten a peer group over various periods, but often have failed to deliver a positive nominal or real return for clients.

A new balanced portfolio, or diversified growth strategy has been growing in popularity recently. This type of multi-asset approach also includes assets such as property, commodities, and possibly other alternative investment strategies. The attractions of this approach are clear. A more diverse set of assets can lead to a less volatile portfolio, and it is an improvement on the two asset class portfolio, but it is still often designed with the objective to match or beat the return of a benchmark or peer group.

The chart below showing the 110-year returns of various asset classes clearly shows the attraction of expanding the investment universe beyond equities and bonds. For example, during the energy crisis of 1973 and 1974 equities and bonds delivered very poor performance as inflation spiked higher. Having the ability to allocate to commodities would have significantly improved traditional balanced portfolios.

Despite a much-improved ability to deliver augmented risk-adjusted returns versus a traditional approach, the diversified growth strategy does fall short of delivering what investors should be looking for, which is a specific objective of long-term real returns and shorter-term risk management.

In an ideal world, investment managers should view risk the way clients view risk. Investment managers should share the same objective as their clients.

There is now a very broad opportunity set for investment managers across asset classes, types of investment vehicles, and types of investment strategies. There is enough flexibility available for the industry to provide products, and run mandates, where the clients’ objectives of preserving capital in the short term and accumulating wealth and increasing purchasing power over the longer term can be achieved.

Risk to most clients is the loss of capital in the short term and the loss of purchasing power in the long term.

We believe the industry has been slow to move to products with target returns and risk constraints aligned with their clients as performance is transparent and there is nowhere to hide. The investment management industry has for decades explained losses by comparing returns to peer groups and benchmarks that also failed.

By recommending clients move to strategies that target inflation-beating real returns, and that have risk budgets that consider risk as the possibility of losing capital in the short term and losing ground to inflation in the long term, the investment industry will be forced to deliver what can become an investment solution for clients, rather than investment products that would have worked in the past.