Will inflation affect my investments?

Investment Team

6 December 2021

As our economy continues to recover from the impact of the pandemic, people have been keen to get back to normal life – and that includes spending some of the money that they were unable to spend during lockdowns on things like shopping, travel, and going out to pubs and restaurants.As businesses have started to pick up again, thanks to more consumer spending, it’s helped our economy grow. 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 as it did before. 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 Prices Index (CPI). To understand CPI, think of a very large shopping basket containing all the goods and services bought by households. The CPI measures the change 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 4.2% over the 12-month period to the end of October 2021. To put this in perspective, it was the highest 12-month inflation rate for nearly ten years. However, while this rise in consumer prices has been making headlines, it’s worth remembering that, compared to spending levels a year ago when movement and business were restricted because of the pandemic, prices are likely to move higher as we start shopping, dining out, and travelling again.

So it’s quite possible that this inflation is a temporary situation as the economy adjusts from the low spending levels a year ago. Certainly, the Bank of England, which sets interest rates, remains of this view. And it’s important to remember that some inflation is a good thing; the Bank of England and the US Federal Reserve (the central bank of the US) say that 2% is a healthy target for inflation.

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 question on investors’ minds are now: if inflation means the economy is recovering, how much longer will central banks continue their helpful policies, such as low interest rates?

These questions help explain why many bond markets have not performed well so far in 2021. Most 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 government bonds, for example – 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, and this often depends on the industry it operates in. 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.

Pensions are a long-term investment. The retirement benefit(s) you receive from your pension will depend on a number of factors including the value of your plan when you decide to take your benefit(s) which isn’t guaranteed and can go down as well as up. The value of your plan could fall below the amount(s) paid in.