Which assets would do best from the return of inflation?

If inflation becomes a genuine concern for investors, it would transform today's markets. John Stepek looks at which assets might prosper amid the turmoil.

Yesterday we talked about the time value of money – that’s the idea that money in the future is worth less than money in the present.

We talked about how we’ve been in an odd period where that gap in value between today’s money and tomorrow’s money has narrowed relentlessly, to the point where sometimes tomorrow’s money is considered to be worth more than today’s (that’s what negative interest rates really mean).

Today we consider what happens when that trend reverses.

Interest rates are far, far lower than their 300-year average right now

Inflation and interest rates are closely tied together. There’s an obvious reason for that: if inflation is sitting at 2%, then you need to earn at least 2% a year on your money for it to maintain its value. Why would I lend you money at 1% a year, if it means I’m going to lose purchasing power? I might as well spend it now. Or put the money somewhere riskier that at least gives me the chance of a decent return, rather than a guaranteed loss after inflation.

So a borrower – which can be a government, or your high street bank (when you deposit money with the bank, that’s a loan from you to the bank) – will usually have to offer you a return that at least keeps up with inflation, and more typically, one that beats it.

For example, according to research published by the Bank of England's John Lewis in 2018 (here’s the piece if you want to read the original), a ten-year UK government bond has typically paid the holder a real interest rate of 2%-3%. That’s the average going back around 300 years. In other words, with inflation at 2%, the ten-year gilt would – on average – yield a bit under 5%.

Things have, however, changed drastically since the financial crisis in 2008. Calculated roughly, using my appalling Excel skills, in the decade running up to the end of 2007, the average real interest rate on the ten-year gilt was just above 3%. In the decade since then, it’s been just under 0% (about negative 0.1% to be more precise).

Why is that? Why would you accept such a massive drop in the real return on your money? The most obvious answer is because you expect things to get even worse. 2008 was a huge deflationary shock and ever since then, much of the global economy has teetered on the brink of deflation.

Markets are all about expectations. So if, as an investor, you expect inflation to turn negative in the future, then you might be happy to buy a gilt yielding 1% at a time when inflation is running at 2%. While 1% might look poor now, you’d rather lock it in because it’ll look good in a year’s time, say.

Rather than all that faffing about with yields, equity investors might prefer to look at it this way: you buy the bond at what looks like an expensive price, because market expectations, the general backdrop, and pure momentum, lead you to believe that it’ll go even higher.

Of course, all this talk of market expectations does ignore the fact that central banks have been buying bonds at any price offered for this entire period. So the market is also underwritten by that promise (although it’s worth noting that during periods of active quantitative easing (QE), bond yields have in fact tended to rise, as investors become less risk averse).

Anyway, so that’s what’s happened in the last decade or more. Investors have bought into the “secular stagnation” theory – the idea that strong economic growth is mostly a thing of the past and that what we all really have to worry about now is turning into something like 1990s and 2000s Japan. In short, they’ve been betting that tomorrow’s money will be worth pretty much exactly the same as today’s. So what happens if that changes?

Even if inflation rises, interest rates might not

Let’s say that inflation and economic growth surprise on the upside. Let’s say it turns out that secular stagnation is wrong, and that the “new normal” was just a blip in the course of the “old normal”, mostly resulting from the painful healing process that always follows a long drawn-out banking crisis.

What would that mean? With inflation rising, one thing it would mean is that the gap between the value of today’s money and that of tomorrow’s would start widening again. And investors would start to demand compensation for that. You might accept a negative real return today if you think that inflation will fall tomorrow. But you’re definitely not going to accept it if you think inflation is going to rise.

So that’s quite a dramatic shift in market psychology. The assets that benefit from rising inflation expectations – commodities and other real assets are the most obvious ones – are not the same as those which benefit from collapsing inflation expectations.

The most vulnerable asset has to be anything that pays you a fixed income. The value to you of a piece of paper that promises to pay you a fixed payment of £100 a year will go up if you expect inflation to fall, but it will drop if you expect inflation to rise. That’s what the bond market is facing.

However, the other big question is: will interest rates rise? And this is where it gets trickier. Put simply, governments can’t afford for interest rates to rise, so they won’t let them. They have many tools available to allow them to do that. This is called financial repression, and in our Christmas podcast (out Monday 21 December), Merryn will be talking to Russell Napier, one of our favourite analysts, about exactly how governments will go about it.

But it creates an interesting scenario. Both interest rates and inflation have been falling in recent decades. We’re now moving into a scenario where we may see inflation rising, but interest rates held static. What happens then? It’s a topic we’ll be discussing at our Christmas roundtable, too (which will be in our end-of-year double issue – get your first six issues free here if you don’t already subscribe).

But we can have a stab at a guess. Even if interest rates remain low, rising inflation will reduce the value of the big promised future cashflows from the likes of Tesla, and increase the value of actual real-life cashflows right now, from the likes of the oil companies, say. To my mind, that implies that the switch from “growth” to “value” (both terrible imprecise terms, but they sum up the point I’m making) has genuine legs.

It also implies that investors who are being denied a real return in one portion of their portfolios, might be forced to try to compensate for that by overweighting sectors with proven defences against inflation – such as commodities – compared to their historical allocations. In other words, you’d expect the inflows we’ve seen into miners and the like to continue too.

I looked at some of the best funds to play these sectors in last week's issue of MoneyWeek magazine. Again, if you haven’t already signed up, bag yourself an early Christmas pressie and subscribe to get your first six issues free now.

Recommended

Will energy prices go down in 2023?
Personal finance

Will energy prices go down in 2023?

Wholesale gas prices are on a downward trajectory, but does this mean lower energy bills later this year?
27 Jan 2023
Best regular savings accounts – January 2023
Savings

Best regular savings accounts – January 2023

You can earn an attractive rate on the best regular savings accounts. We tell you the best on the market to take advantage of right now
27 Jan 2023
Equity release v downsizing – which is best?
Personal finance

Equity release v downsizing – which is best?

Equity release hit a record high in 2022. But is downsizing a better way to hold on to your money?
27 Jan 2023
Self-assessment tax returns: what you need to know about getting your tax bill right
Income tax

Self-assessment tax returns: what you need to know about getting your tax bill right

Understanding how self assessment works can help you ensure you pay the right amount of tax, as well as avoid penalties for missing the deadline.
27 Jan 2023

Most Popular

House prices could fall 30%. Should investors be worried about a repeat of 2008?
Investments

House prices could fall 30%. Should investors be worried about a repeat of 2008?

Some analysts are predicting that house prices could fall as much as 30%, which, when compared to the fact that prices have jumped 28% since April 201…
24 Jan 2023
Will energy prices go down in 2023?
Personal finance

Will energy prices go down in 2023?

Wholesale gas prices are on a downward trajectory, but does this mean lower energy bills later this year?
27 Jan 2023
Council tax increases 2023 – how much more will you pay?
Tax

Council tax increases 2023 – how much more will you pay?

Your council tax bill will go up in April - we reveal the councils that have confirmed what this year’s increase will be.
23 Jan 2023