Inflation awakes

I suppose that if you were to distil the investment advice given within these pages down to a minimum objective, it would be to ensure that the net return (ex-dealing costs and tax) of readers' investments outstrips the rate of inflation. Straightforward enough one would think, especially in a nominally low-inflation environment, and given that there's seemingly no shortage of tools at our disposal: equities, bonds, property, gold and derivatives - you name it. But, as I'm sure you have noticed, we are living through 'interesting times' - in the Chinese sense - and they're probably going to get a little more interesting as time moves on.

It's by no means certain, but there is a possibility that if the US economic recovery gathers momentum the quantitative easing measures taken by the Federal Reserve in recent years will result in strong inflationary pressures - the salient question is how strong? Most standard investment portfolios - even 'late-term' models with high exposure to fixed interest securities - can cope with modest rates of inflation, but what happens when the consumer price index (CPI) climbs to 5, 6 or 7 per cent? The annual CPI rate has only edged into that territory three times in the past 24 years, although whether the official rate reflects actual cost increases is highly debatable. Of course, given the extraordinary set of circumstances at play within the wider economy, you'll probably read as many warnings about liquidity traps, and the imminent danger of western economies slipping into a decade of Japanese-style stagflation, but these matters are beyond our control – so let's focus on the preservation of accumulated wealth.

Running out of silver bullets

The trouble is that most investors are already convinced that governments have been trying to inflate their way out of debt, or keep their currencies artificially low in order to retain competitiveness in export markets. The orthodox view is that defensive asset allocation can be effective against a sudden unexpected surge in inflation. By diversifying your investments across a range of asset classes, you can insulate your portfolio by participating in categories that have traditionally benefited from rising prices or currency weakness (commodities and real estate, for example). However, that doesn't hold true once the cat is out of the bag - the expectation of inflation gets priced into assets and securities well in advance. And that unfortunately is where we are now.

When you read the advice offered by our specialist writers in this article, what emerges is that a number of commonly held assumptions on the best ways to safeguard your assets against inflation no longer apply (or perhaps never did). For example, the viability of no-fuss investment options, such as higher-rate, fixed-term deposit accounts, is open to question due to the ultra-low interest rates now in place across western economies. In short, there is no 'one size fits all' solution to the problem; you can't simply buy into a particular sector, or start hoarding bullion in expectation that your capital will be covered. But it is certainly possible to build a portfolio that will offset the worst ravages of inflation, particularly over the long term. We can't offer any single fail-safe mechanism to preserve your capital, but there are still options for the wary investor.

Within the equity spectrum, Algy Hall has revised his 'inflation-beating' stock screen, which highlights how important reinvested income can be to the process. And we highlight some sectors that have often been favoured by investors during previous inflationary periods, but are no longer quite so reliable. Investments in grocers such as Tesco and Sainsbury were traditionally seen as bulwarks against inflation but, as our retail analyst Julia Bradshaw points out, the 'pricing power' previously enjoyed by these high street stalwarts has been gradually eroded, although she does identify some interesting alternatives within the sector. The big utility companies can provide a useful equity option if inflation starts bubbling up - it's not as though people ever stop buying gas, water or electricity. But as the accompanying analysis suggest, you will need to look closely at where these providers are in terms of the regulatory cycle.

If you borrow, borrow big

Many investors would doubtless cite real estate as a safe repository for capital in an inflationary environment - however, our property guru Stephen Wilmot counsels caution given the complex and oftentimes conflicting factors at play in property markets, although he helpfully concludes that "taking out a mortgage is the best inflation hedge of them all". Stephen may have a point. After all, Aristotle Onassis once said, "if you borrow, borrow big" - and it seems his compatriots took him at his word, or at least their government did - but only ever do so on the basis that any mortgage debt incurred can be safely serviced.

Agreeing to disagree

Elsewhere within this article, IC economist Chris Dillow explores whether a definitive correlation exists between equity index performance and inflation. This analysis sets out the reasons why there seems to be no overriding consensus. Like many seemingly simple propositions, there's an underlying level of complexity. What readers may still find perplexing, given the amount of data at hand, is the sheer divergence of opinion among economists on this relationship, although as George Bernard Shaw once said: "If all economists were laid end to end, they would not reach a conclusion". John Maynard Keynes

Nevertheless, it's a critical question for our readers, particularly those with a high proportion of their investible capital locked into equities. As I mentioned, consensus is hard to find on whether equity investments act as an effective hedge during inflationary periods, but it is generally held - perhaps somewhat counter-intuitively - that they are more effective in this regard the longer the period in question. There also seems to be general agreement that shares have tended to produce a positive net return when inflation is relatively modest and stable, but they have come up short during periods when it has moved sharply higher - around 5 per cent or more. Naturally, we'll also be giving the lowdown on whether the perceived wisdom that exposure to 'hard assets' such as gold provide the best protection against this 'destroyer of prosperity'.

Lies and damned statistics

If you're trying to make a judgement about the likelihood of a prolonged inflationary period in the UK, it would be useful if the metrics used to measure it were accurate, but the basis of calculation for the CPI - the rate utilised by the government since 1996 - has regularly been brought into question by economists. Perhaps this is unavoidable, given the obvious complexity of the task involved, but it's not simply an academic matter, or an indicative measure. The rate certainly takes on a tangible dimension if your annual pay increase is predicated on the official rate, or if, say, you're one of the millions of retirees that have bought an index-linked pension. In fact, there are few western governments that haven't made changes to the way in which their benchmark inflation rate is calculated. In the US, for example, the way in which inflation is calculated has been changed more than 20 times in the past 35 years. For those who take a sceptical view of official data, an illuminating website – albeit one that focuses on flaws in US government economic data rather than the UK data - is John Williams' Shadow Government Statistics (shadowstats.com).

There are regular criticisms levelled at the CPI, but the overriding fact is that it is consistently lower than the RPI measure previously employed; since 1996 the cumulative inflation rate shown by RPI is 57.7 per cent while that for the CPI is 37.4 per cent. If you quit work in 1996, it's unlikely that you would want to draw your pension based on the latter measure. The change has forced down real wages and reduced pension payments for millions.

What is inflation actually running at? According to the CPI, the annual inflation rate in the UK has averaged 2.85 per cent over the past decade. While most householders would simply scoff at this figure, it would certainly hold true if you were analysing prices for most manufactured goods, as opposed to energy, fuel, water and food - although the latter category is the source of much debate. Nevertheless, the changes in methodology that have been the basis of the CPI have moved the balance away from measuring the costs of maintaining a basic standard of living, in favour of discretionary spending. As a result, this disproportionately understates the inflation rate in relation to people on lower or fixed incomes. Even employing the official rate, the average real UK salary is shrinking by nearly 1 per cent a year as the rate of household inflation more than wipes out meagre pay increases.

Should you buy gold?

The central banks of many of the world's biggest economies are all engaged in policies designed to devalue their currencies. Only last week the Bank of Japan - in an escalation of the so-called 'currency wars' - announced that it was embarking on a "massive" government bond-buying program, which will double Japan's monetary base. Japan is just one of a number of countries aiming to debase the value of their currency and increase their competitiveness. Central banks will be hoping to achieve a significant devaluation, with inflation ticking along at manageable levels. However, as experience demonstrates, once inflation is off the leash the usual consequences include surging interest rates, large-scale job losses and even recession to stop the erosion of the currency.

While governments don't seem overly concerned about the latter prospect anymore, investors obviously need to be. The popularity of gold-backed exchange traded commodities in recent years is a clear indication that investors are increasingly wary of declining fiat currencies. The clamour for these types of contracts has also helped drive the gold price, although it has probably been a factor in depressing stock market prices for listed gold mining companies given that they were traditionally the means by which investors gained exposure to the metal. (Access to physical gold is an option, but has a number of drawbacks - including dealer and storage costs - and the fact that the market is far less transparent and liquid than you would imagine.)

Fear is the key

Many of our readers who have opted for exposure to gold as part of their portfolios would have noticed the polarisation of views as to how useful it is as a hedge against inflation. The gold lobbyists have obviously been gaining ground as governments continue to play fast and loose with monetary policy, and a number of comprehensive academic studies conclude that the purchasing power of the metal has held up remarkably well over the long run, although there are periods when this certainly doesn't apply (1980-2011, for example). The contra-argument runs that as a proper investment gold is impossible to value and produces no cash flow or dividends. Last year, Warren Buffett made the point that for $9.6 trillion (£6.3 trillion) you could buy all the gold in the world (at $1,750 an ounce), or you could purchase all the cropland in the US (400m acres), together with 16 Exxon Mobils, and still have $1 trillion in spare change. The point he was obviously making is that an investment in gold is essentially moribund, with a value predicated primarily on fears for the debasement of the greenback and other currencies. Of course, there's no shortage of that at the moment, so the real issue isn't linked to the long-run bull market in gold but, rather, on how low – and for how long - the dollar can fall. On that basis, gold bugs will probably feel vindicated for a while yet, but Mr Buffett also points out that the rising price itself - as seen with other asset classes - takes on a momentum of its own, drawing in purchasers who see the rise as "validating an investment thesis".