AT ITS root, the minimum goal of most investors (as opposed to speculators or traders) is not to avoid losses, but to preserve purchasing power over the long term.
For much of the past 30 years, this has not been too challenging, since a declining inflation rate and reasonable interest rates on short-term deposits have meant that the task has equated to that of preserving capital in absolute terms.
This is no longer the case. Many commentators are now suggesting that the path of inflation may be upwards for some time to come, while, at the same time, interest rates on bank deposits are at record lows.
Investors, therefore, are increasingly on the hunt for alternative “insurance policies” against the erosion of purchasing power that would result.
For some clues as to what to do, let us time travel back to the 1970s, the last episode when inflation was rampant.
Looking at the key asset classes, during the 10-year period from 1970 to 1980, according to data taken from the Barclays Equity Gilt Study and rounding to the nearest whole number, in a period when inflation compounded at just over 13%, shares delivered a nominal compound annual total return of 10%, cash 9% and bonds 8%.
Putting it simply, it looks as if there is no hiding place, with equities the best of a bad lot.
However, a more detailed inspection of the period reveals deeper lessons to be drawn from the historical context.
Specifically, looking at the second half of the decade, inflation was actually higher at 15%; however, equities returned an impressive 36%, cash only 10% and bonds 18%.
Although this was an unusual period (1974 was the UK’s 1929 for shares) the important point to grasp is that the damage to equities was done early in the decade, when the problem was one of “stagflation” – an inflationary shock that also destroyed demand and profits.
When growth resumed, equities delivered much improved returns and were, in fact, a good “insurance policy” against the ravages of inflation. Cash, on the other hand, saw a sustained erosion in value throughout the period, and bonds were uncertain friends.
Clearly, we must be careful of drawing too many conclusions from a single example, particularly such an extraordinary one.
Nevertheless, unless there is another stagflationary episode, there are good reasons to believe that equities will again provide good protection against any increase in inflation in the upcoming decade.
Why is this?
It is because the source of the inflation will likely be demand growth in export-driven emerging economies (principally China), transmitted into the developed world through raw material prices.
Since Chinese consumers are now also feeling the pressure of rising prices, the consequence is likely to be a more accommodating exchange rate policy, which will moderate local inflationary pressures but not those of China’s trading partners in the developed world.
Large blue-chip international companies have both exposure to the growth offered in these emerging markets and the ability to protect their margins in the developed world through efficient purchasing and pass-through mechanisms.
We are, therefore, buyers of shares in these companies, happy that they will contribute to our mission to preserve purchasing power over the intermediate term.
John Haynes,
Head of Research,
Rensburg Sheppards
