How to protect against inflation

Rick Eling, head of investment solutions at Sanlam UK, offers tips on protecting your clients’ portfolios against inflation

All things decay; wealth is no different. When purchasing power rots away we call it inflation. It comes by stealth: you will not find mould growing on your ten pound note. But its value is slowly wasting away in your wallet.

And not always so slowly. Inflation has a mutant cousin that can sweep away whole countries: hyperinflation. This usually benign force takes on extraordinarily destructive powers.

So how can an investor protect their wealth from inflation?

CPI or RPI?

The first challenge is to identify the inflation target you are up against. Consumer price index (CPI) or retail price index (RPI) is the first question. The Bank of England’s official target since 2003 has been CPI, and yet RPI still plays a role as the basis for some investment returns and pay settlements.

The most well-known difference between the two measures is that only RPI includes mortgage interest payments. This makes it more sensitive to interest rate changes. The biggest difference is the way they are calculated: RPI is an arithmetic average; CPI is geometric.

CPI and RPI are both aggregate measures. They do not necessarily reflect your personal rate of inflation. This depends on the goods and services you buy, and on the proportion of your income spent on each item.

Food price inflation, for example, hurts the poor more than the rich. Poorer people do not need less food to stay alive, but they have less total income to spend on it.
The BBC website offers a personal inflation calculator. A sample of 50 people in a typical British office would show a wide range of inflation rates based on lifestyle, income and housing. It is common for particular groups of people to experience deflation while the broad economy inflates. The point is that protecting an investor from a headline inflation measure might not save them altogether.

Various assets are claimed to offer protection against inflation: gold; other commodities; equities (especially defensive stocks); and index-linked gilts. But do they deliver?

Gold

Gold is the classic inflation hedge. The old story goes that an ounce of gold in Roman times would buy a handmade suit (presumably a toga, unless Cicero wore a pinstripe single-breasted number); and an ounce of gold today (roughly £900) will also buy a handmade suit. While this is a nice anecdote, there does not seem to be a clear correlation between changes in the spot price of gold and changes in inflation. One theory is that gold is used as a global master currency to hedge against weakening national currencies.

Gold’s case is helped by its performance in the inflationary 1970s: the price went up by more than 17 times in the decade, from $36.02 an ounce in 1970 to $615 an ounce in 1980. But there is a severe price risk. Gold went on to collapse nearly 50% from its 1980 level in less than two years.

Gold is a special case because of its longstanding status as a universal store of value. So what about other commodities? Oil exchange traded funds (ETFs) could hedge against rising petrol prices; wheat futures against food prices. The difficulty is that these are volatile instruments – it would be very tricky to allocate capital correctly to provide a counter return against inflation.