Will inflation affect my investments?
Kerry Smith
10 June 2021
As our economy starts to recover from being shut down for the better part of a year, people are eager to get back to normal life – and that includes spending some of the money we were unable to spend during lockdown on things like shopping, travel, and going out to pubs and restaurants.
As those businesses start to pick up again, thanks to more consumer spending, that’s helping our economy start to grow again. But of course, one side effect of higher demand is higher prices – otherwise known as inflation. For consumers, higher prices lead to a loss of “purchasing power” – meaning that your money simply doesn’t go as far. But from an investment perspective – for instance, if you’re saving into a pension or are taking an income from it in retirement– you might be wondering how inflation could affect your savings.
Why do financial markets care about inflation?
Inflation is measured in the UK using the Consumer Price Index (CPI). To understand CPI, think of a very large shopping basket containing all the goods and services bought by households. The CPI measures changes to the total cost of this basket over time. It's normally expressed as a percentage increase or decrease in prices over a set period of time.
In the UK, inflation rose by 1.5% in April 2021, which was the biggest rise since March 2020. While this rise in consumer prices has been a making headlines, it’s worth remembering that, compared to spending levels a year ago when lockdowns were first imposed, prices are naturally going to move higher as we start shopping, dining out, and traveling again. So it is quite possible that this inflation is a temporary situation when compared to a year ago.
What’s more, both the Bank of England and the US Federal Reserve (the central banks of the UK and the US) have been saying for a number of years that 2% is a healthy target for inflation – and we are still below that level.
So what does that mean for my pension?
Your pension is usually invested in shares, bonds, and occasionally property or other types of investments. What inflation means for your pension will depend on the type of investment – inflation can be helpful in some markets and not so helpful in other markets. Let’s take a closer look.
One thing that could affect markets is how central banks might react to the higher consumer prices. In many ways, central banks have been supporting the economy since the pandemic first hit, because they set interest rates, and create the nation’s monetary policies. So the questions on investors’ minds are now: if inflation means the economy is recovering, how much longer will central banks continue those helpful policies? How much longer until they raise interest rates?
These questions help explain why bond markets did not perform well in the first half of 2021. Bonds offer a fixed level of interest payments over a set period of time. If inflation is rising and your money is worth less, then the fixed rate becomes less appealing. So the value of bonds – traditionally considered a steady if unexciting investment – has had more ups and downs this year, taking investors on a bit of a bumpy ride of late.
Shares in companies can also be affected by inflation, depending on the type of company. Some company shares won’t perform well in a higher-inflation environment, but some will do better because of inflation.
No one particular type of investment offers total protection against inflation. But historically, investment growth over the long term is higher than inflation. So, normally, staying invested gives you a better chance to keep ahead of inflation. What’s more, investing in different types of investments (called “diversifying”) and keeping a long-term outlook may offer protection against whatever the future may hold.
What’s ahead
Over the next year, inflation will still be a hot topic and probably lead to some short-term ups and downs in financial markets. But it’s worth remembering that it’s most likely temporary, and – importantly – that it’s the result of a return to economic growth. In our view, this is cause for optimism about the prospects for investment growth over the long term.