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Inflation rise: economic success or cost of living crisis?

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18/11/2014
News that UK inflation has edged higher was hailed as a sign of the improving economic outlook by the coalition and a sign of the cost of living crisis by the opposition. Who is right?

Liberal Democrat Chief Secretary to the Treasury, Danny Alexander said that the figures showed the UK economy was in good shape: “Consistently low inflation helps give businesses the confidence to invest as well as helping with family budgets…There are clearly risks ahead arising from uncertainties in the Eurozone and global economy. But combined with record job creation and strong growth, today’s figures show that our recovery plan is working and that we are continuing to make progress.”

In contrast, Catherine McKinnell MP, Labour’s Shadow Treasury Minister, said that the figures showed a mounting cost of living crisis: “Working people are £1,600 a year worse off under David Cameron’s government because for four years wages have lagged behind price rises.”

However, most commentators believe the real reasons behind the small rise (0.1 per cent) show neither a cost of living crisis, nor economic success:

Ben Brettell, a senior economist at Hargreaves Lansdown, says: “Fuel costs and air fares were the main reasons behind the rise. Both have fallen since last month, but this time last year there was an even larger fall between September and October, leading to an upward impact on the year-on-year figures.”

Brettell says that the outlook for inflation remains weak and may fall below 1 per cent: “Bank of England Chief Economist Andy Haldane said in a speech yesterday that he is watching UK inflation expectations “like a dove”. This is a clear indication that he expects weak inflation to allow the Bank to maintain its ultra-low interest rate policy for some time.”

He supports David Cameron’s view that storm clouds are gathering for the UK economy, adding: “The exceptionally weak economic performance of the euro zone – our largest trading partner – remains a severe threat, while data released this week showed that Shinzo Abe’s radical reforms have failed to prevent the Japanese economy slipping back into recession. Given these threats, and the absence of inflationary pressure, it is difficult to see why the Bank of England would consider raising interest rates at present.”

Richard Jeffries, chief investment officer at Cazenove Capital, says that the UK economy is losing momentum at the moment: “It looks increasingly likely that interest rates will remain unchanged for most of 2015….wage inflation is starting to show signs of picking up, but growth is likely to level out at 2.5 per cent, a much more sustainable rate in the long-term.”

Nevertheless, while weaker UK growth suggests that there is no immediate risk of higher inflation, investors should still ensure that their savings are protected over time. Vanessa Owen, LV= Head of Annuities and Equity Release says inflation is a particular risk for retirees: “With people spending longer in retirement, the risk of inflation eroding someone’s purchasing power is an issue that should be considered when deciding how to structure their income. While there are retirement solutions available that provide an element of inflation-proofing, the majority of annuities are purchased on a level basis. However following the pension reforms we expect this to change as increasing numbers of retirees look to alternatives such as fixed term and investment linked annuities.”

Investors should recognise that holding their savings in cash is not the ‘safest’ option over the long term. Fidelity’s Tom Stevenson gives his tips for protecting your portfolio against inflation:

1. Invest in equities

In a modestly inflationary environment, equities are a good hedge against rising prices. This is because shares represent a real claim on a company’s assets and its cash flows which can rise in line with prices if a company has any pricing power.

Inflation rising to about 4% from a low base is often associated with rising equity valuations because it usually means that the economy is recovering. Inflation rising much above this level, however, can result in valuations falling back again because it can be associated with rising interest rates. Rising longevity means retirees should consider a higher equity weighting than was considered appropriate when people did not live so long.

2. Gain exposure to real assets

Real assets offer some protection against inflation – these might include things like airports, oil wells, property and other infrastructure. Shares in companies exposed to these assets are a much more flexible way of accessing this protection than the assets themselves, which can often be quite difficult to trade in and out of.

3. Exploit the compounding benefits of income

Equity income can be attractive in a modestly inflationary environment because the compounded growth of reinvested dividends can maintain the real value of your investments. Reinvested income provides the lion’s share of total returns over the long run.

4. Consider assets that are scarce

Always buy the best, scarcest assets you can and especially things that they can’tmake any more – land, prime property in world-class cities, wine and classic cars can all do well in inflationary environments but the latter two are also prone to horrendous busts as well as booms. Take great care with these.

 

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