Consumer prices in the United Kingdom increased 0.3 percent year-on-year in May. At this low level, and after years of falling headline numbers, investors may be forgiven for not giving this too much thought. However, despite the historically low inflationary environment, the longer term effects and the power of compounding cannot be ignored – the value of £100 ten years ago, for example, is worth less than £80 today.
Einstein once said “Compound interest is the eighth wonder of the world. He who understands it, earns it, he who doesn’t, pays it.” Inflation can be seen as a compound interest which we are all forced to ‘pay’, and by understanding it we should seek to find assets which consistently protect against it in the long term.
Equities, property, inflation-linked bonds and commodities are often championed as hedges against inflation, but none of these are perfect; property is illiquid and vulnerable to prolonged periods of depressed values; inflation-linked bond prices are influenced by inflation expectations, which are only loosely correlated with changes in actual inflation; and commodities can be volatile and do not provide an income. Equities are also volatile in the short term but are arguably the most reliable source of real returns over the long-term, not least because the underlying companies buy and sell products at prevailing market prices. In any five year holding period over the last 30 years, for example, UK equities produced a real (above inflation) return 80% of the time.
It is this relatively reliable ability to generate attractive real returns over time that leads us to build long term portfolios around a dominant core of equity exposure.