How you can hedge against inflation

Residents of the UK have enjoyed stable living costs for many years. When we compare, say, £1,000 sitting in a savings account today with the same sum a year ago, we don't say to ourselves 'ah, but prices have gone up by 2.5% over the year, so really it is worth a bit less.' At the back of our minds we know that the inflation rate is somewhere around 2.5%, but it is too small a figure to care about.

We tend to think that high inflation only happens in the easily-dismissed and so-called third world countries. Indeed countries making the headlines with their inflation rates in 2006 have included such exotic locations as Zimbabwe and Turkey. It was not always so. The UK was home to near 25% inflation in the mid-1970s, a time when sterling also depreciated rapidly against major currencies, further reducing the wealth of British citizens on the global stage.

Why the inflation effect is more than you think

2.5% may seem a tiny figure, but in the context of historical long-run equity returns in the region of 7%, it is a significant chunk of the total. All the more so if we are in the habit of spending all our dividend and interest income, rather than setting-by a part of the 'income' to compensate for our capital's loss of purchasing power.

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Let me add a zero to illustrate things further. With an inflation rate of 25%, prices double every four years, right? Wrong. Thanks to the wonder of compounding, with 25% annual inflation it takes less than three years and two months for prices to double and our purchasing power to halve. Savers and investors trying to build up a capital sum to live on in retirement would need twice the capital sum simply to stand still, and have just three years and two months in which to generate it. This is a totally unobtainable objective, but one which became the harsh reality for British savers in the 1970s.

Hopefully our readers, particularly the younger ones, have considerably more than three years and two months in which to build up their capital. And the figure of 25% for inflation is clearly ridiculous.

Or is it? We all spend our money on different things, but the rate of price inflation in many goods and services (gas and electricity, petrol, motor insurance, council tax and private education fees for children, to name but a few) has a trajectory utterly removed from the official CPI figure of around 2.5%. We are not talking about living costs doubling again in under four years, but neither should we remain under the illusion that current inflation does not matter. It does.

How companies can make money and still go broke

The same is true for companies as it is for investors. Companies have a capital base which they need to keep growing ahead of the rate at which their purchasing power is being eroded. The 1970s and 1980s saw companies going out of business despite the fact that they were reporting profits. Indeed the phenomenon became so rife that the UK accounting profession was forced to develop and introduce new accounting standards specifically to deal with the problem of accounting in an inflationary environment. Let me give a hypothetical example of the sort of situation that could just as easily happen

today:

X plc is a UK-based manufacturer, using specialist machine tools imported from China to manufacture components for the UK automotive industry. It has shareholders' funds of £100m, of which £80m is tied-up in brand new machine tools. These have a life of four years, resulting in a depreciation charge each year of £20m. The company's net profit last year was £15m, a respectable 15% return on shareholders' funds.

Fast forward four years and it is time to replace those machine tools. They still come from China and have a four year life, but the price is now £100m, rather than £80m. The depreciation charge goes up from £20m to £25m, making profits suddenly drop from £15m to £10m. That's a massive 33% fall in earnings, and probably the share price too, simply because the company had been basing its depreciation charge on the historic cost of its machinery, rather than replacement cost. And the rate of annual inflation that had nudged Chinese machinery prices from £80m to £100m in four years? Do the maths and it works out at just 5.75% each year. Be under no illusion, even modest single digit inflation can have a catastrophic impact on our investments.

The added real-life dimension to this example is that, having set aside £80m over four years in line with the depreciation charge, there simply is not enough cash in the bank to fund the £100m required to replace the machinery and stay in business. Not only have profits been overstated, but the company has paid out too much in dividends to be able to afford the machinery on which its business depends.

House price inflation and current purchasing power

This brings me to the all-important concept of 'current purchasing power' during times of inflation. An obvious example of this is perhaps the roof over our heads.

After the UK's prolonged period of rising house prices, it is easy for homeowners to pat themselves on the back. 'We bought our house five years ago for £250,000 and today it is valued at £500,000. We've made a cool £250,000 profit.' Just like Company X in my example above, anyone uttering those words is deluding themselves about their profitability. Try replacing that same house today with an identical one and it won't cost you £250,000 (leaving you £250,000 of cash in the bank). It will cost you £500,000 to replace. You bought yourself a house five years ago, and that is precisely what you have today a house.

Interested in property? See our section on investing in property & housing for articles on mortgages, self-build homes, the US property market and more.

In real, current purchasing power, you are no wealthier. And, as I'll demonstrate shortly, that same house could now land you with a big tax bill should you fail to take steps to protect your estate from IHT. Oh, and the costs of running that same house council tax, insurance, utilities, repairs and maintenance are now a multiple of what they were five years ago. Still think you've made a £250,000 profit?

What you have done successfully, however, is 'hedge' yourself against one specific component of the overall rate of inflation that affects our daily lives house prices. Contrast this with someone not on the housing ladder and who held back from buying five years ago. For them the rate of inflation in housing, a necessity of life, has been nothing short of catastrophic.

The lesson to draw from this is that the CPI can be utterly irrelevant and misleading for anyone wanting to maintain their current purchasing power. For Company X above, the rate of inflation key to its well-being was the rate at which the price of its imported machine tools was escalating. For anyone trying to get onto the housing ladder or trade-up into a bigger property recent house price inflation has been key. Someone dependent on the heavy use of their car will feel the financial impact of an escalation in oil prices more than someone who does not need to travel.

Each one of us must assess what measure of inflation affects us most and hedge appropriately. A high mileage driver should arguably hold investments that are positively correlated to a rising oil price. He loses at the petrol pumps, but wins with rising dividends and capital gains from his oil stocks.

How rising prices relate to taxation

Taxation can become particularly pernicious during times of rising prices. The reason is that tax bands and allowances are set in 'nominal' terms, whereas asset prices and income levels are 'real' and impacted by inflation. The nil-rate band for inheritance tax, set at £285,000 for the current year, has utterly failed to keep pace with the rise in prices of the principal component of most UK estates; the house. Consequently, in terms of current purchasing power, it is often no longer possible to leave a modest house to one's beneficiaries. They now only get a house if they can also fund a significant tax bill.

Capital gains tax and income tax become 'progressive' too in times of inflation. The annual nil rate CGT band, currently set at £8,800, effectively allows capital sums of up to £352,000 to grow in line with inflation at 2.5% without being taxed (£352,000 x 2.5% = £8,800). If your capital appreciation is greater than this, you can expect to be paying CGT simply on inflation. While £352,000 is a significant sum, it is sufficient to generate only a modest income in the region perhaps of £14k before tax in retirement.

Want to know more about capital gains tax? Then see our section on tax.

The income which such a capital sum could generate would be barely adequate to subsist on in retirement. The old CGT system of Indexation Allowances at least had the merit of stripping inflation out of the charge to tax.

The Taper Relief system, which replaced Indexation Allowances from 1998, makes no concessions to falling purchasing power. In a system that is more straightforward to calculate, but which lacks any economic justification whatsoever, short-term gains are now taxed at a higher effective rate than gains that take longer to be realised or accrue.

Even income tax on interest income hits harder as inflation rises, leaving the investor with less in real terms. Rates are effectively made up of a real rate (which tends to stay much the same at about 2.5% in the UK) plus an element to reflect inflation expectations. These are currently around 2.25% in the UK, leading to a combined base rate of 4.75%. Were inflation expectations to pop up by one percentage point, it is likely (all other things being equal) payment rates would rise by one percentage point too.

While the real rate of return on money has remained unchanged at 2.5%, investors pay income tax on the full and nominally higher level of interest income. The iniquity is that post-tax, their purchasing power actually falls. Income tax on interest income becomes a tax on inflation.

Indeed governments can benefit financially from inflation in two rather sinister ways. Firstly, tax can be collected on assets and income where it was not payable before. Secondly, where a government borrows heavily as the UK's certainly does a healthy dose of inflation whittles away the real burden of its borrowings. With the UK's national debt standing somewhere in the region of £425bn, another percentage point on inflation writes-off the real cost of repaying that debt by a most helpful £4.25bn each year. It is perhaps best not to dwell on the thought that much of that debt is provided by our pension funds through the gilts market.

This last point will, I hope, make clear the danger of holding gilts, bonds or other fixed income investments during times of price inflation. Look at these instruments, perhaps, as being like the counterparty to your house payment deal. You may have used house payment finance to buy property, seen it rise in value, and then, years later, redeemed the loan by paying back the same sum that you borrowed. You may have prospered, but the provider of that debt finance has seen the purchasing power of their money crumble. In times of inflation, a borrower rather than a lender be.

What can investors do to protect themselves?

So what should investors do? Certainly avoid fixed income investments, long-term cash balances, and index- linked products linked to inappropriate indices. Gold comes into its own as a store of value when confidence wanes in paper currencies. Paying no income, gold will also not land us with tax on the inflation element of income. ISAs can be used to shield investments from CGT and higher rates of income tax. Investment trusts and unit trusts too, because they can realise gains free of tax within their funds, are helpful long-term vehicles.

We should also look ahead to the day when capital assets need replacing. At the root of inflation we see rising prices of oil, metals and other natural resources. If rising commodity and energy prices are the principal risk to our personal purchasing power, it makes sense to own stocks which will prosper from them.

By Andrew Vaughan for The Daily Reckoning. You can read more from Andrew and many others at www.dailyreckoning.co.uk