Inflation is on the march again. Since the beginning of the year, the annual rate of headline inflation has more than tripled in the UK to 2.5%1. Inflation is often seen as bad news for some investments, particularly if interest rates are pushed up sharply to combat the upward pressure on prices. But how worried should investors be and what should they do about it?

At Vanguard, we suspect that we are experiencing a one-off surge in inflation caused by the economy’s return to normality as lockdown restrictions ease and pent-up demand returns. As outlined in our mid-year 2021 outlook, we expect the rate of increase in UK inflation to peak slightly above current levels by the end of the year. As a result, we don’t think the Bank of England will raise interest rates until 2023.

Despite this relatively benign outlook, inflation can still erode the value of your savings over time, as the rising cost of goods and services eats away at the purchasing power of your money. This can be particularly true with cash savings, where you are unlikely to earn enough interest to outpace inflation. If interest rates on cash accounts are 1%, say, but inflation is running at 2%, you are in fact earning a negative return of 1%. It is one of the key reasons why investors may choose to hold a portfolio of assets such as shares and bonds, which have the potential to earn higher returns over the long term.

So how can you protect your portfolio from inflation?

Shares as an inflation hedge

The good news is that shares have been pretty reliable generators of real (inflation-adjusted) returns over the long term, across periods of both high and low inflation. Our table below shows how three asset classes – UK shares, UK bonds and UK Treasury bills (a proxy for cash) – have performed over the last 120 years.

Nominal

1900-2020 total returns Average annual return % of years with negative return Greatest annual loss*
100% treasury bills 4.62% 0% -
100% bonds  5.60% 28% -9.71%
100% stocks 9.17% 28% -18.70%


Real (inflation-adjusted)

1900-2020 total returns Average annual return % of years with negative return Greatest annual loss*
100% treasury bills 1.01% 35% -10.32%
100% bonds 1.96% 43% -18.84%
100% stocks 5.41% 33% -21.43%


Past performance is not a reliable indicator of future results.

*Greatest annual loss is represented by the lowest 5th percentile of annual returns. Notes: Data cover 1 January, 1900 to 31 December 2020. Returns are in GBP. Nominal value is the return before adjustment for inflation; real value includes the effect of inflation.

Sources: Vanguard, using Dimson-Marsh-Staunton global returns data from Morningstar, Inc. (the DMS UK Equity Index, the DMS UK Bond Index and the DMS UK Bill Index).

Cash has produced a negative nominal (before inflation) return in none of the years examined whereas stock market returns have been negative in 28% of them. What is striking, however, is that we see a different picture when looking at real (inflation-adjusted) returns, with cash delivering a negative return in 35% of years examined. That’s more than shares at 33% of years and overall shares have delivered an average real return of 5.41% over the past 120 years compared with 1.96% for bonds and only 1.01% for cash.

In some respects, that makes intuitive sense. Some companies and sectors have inflation-hedging strengths because they are able to transfer their higher costs to consumers (for example, energy companies) or because demand for their products or services is relatively static (for example, drugs or tobacco manufacturers), which in turn supports their profits and how well their shares do. But it is not always obvious which other factors might impact stock prices during periods of rising inflation, so it is always important to hold a well-diversified portfolio of companies across regions and sectors.

The table above also shows that global bonds have delivered a relatively large maximum annual loss in real terms, but this does not change the rationale for holding bonds in a balanced portfolio. In fact, bond prices have historically tended to move in the opposite direction to share prices, especially during periods of prolonged market stress, and therefore act as shock absorbers in a balanced portfolio of bonds and equities.

Bonds and inflation

Bonds can struggle when inflation emerges as an issue for investors. They tend to be hit by rising interest rates because the fixed nature of the income that investors receive from bonds – their coupon payments – means they can only remain attractive to buyers by falling in price. This is indeed what’s happened over the past year or so as investors have anticipated higher rates. Since bonds with longer pay-back periods will tend to be hit harder by rising rates, some investors have also allocated more to shorter-term bonds.

But the key thing for all bond holders is what will happen in the future. It’s only if rates actually move higher than expected that bonds suffer further significant falls. So those who sell now are locking in past losses and may forego a valuable buffer against other unexpected shocks to their portfolio.

More generally, while rising interest rates can mute the performance of bonds over short time horizons, the impact of rising rates is more complex. In fact, bond total returns have two main components – the price return and the return from income. As interest rates rise, for instance, these two components tend to move in opposite directions, with the return from income offsetting the declining price return over time. Long-term investors should therefore care about the total returns from bonds instead of the negative short-term impact on bond prices and, as a general rule, the starting bond yield is a good predictor of future bond returns.

Looking ahead, Vanguard’s outlook for bond investors now is in fact better than it was at the start of the year, with projected 10-year annualised returns for bonds around 0.5 to 1 percentage points higher than at the end of 2020 due to the rise in yields we have seen2.

Investors could also consider holding some of their portfolio in UK index-linked government bonds (“linkers”) or US Treasury inflation-protected securities. These provide inflation-linked increases in both capital and interest, helping to manage inflation risk within the bond portion of your portfolio. This is why Vanguard’s LifeStrategy funds, which offer different blends of shares and bonds within one portfolio, contain an allocation to inflation-linked bonds.

Alternative investments

Investors sometimes look to less mainstream investments, such as gold, commodities or property, to keep pace with inflation.

Gold and commodities have historically tended to perform positively when inflation is rising, so investors who are mostly concerned about inflation risk may consider some exposure to these two asset classes.

However, our analysis has shown that adding commodities to a portfolio also increases the volatility of that portfolio, so there is a trade-off between insulating your savings from inflation and taking on more risk3.

Meanwhile, listed property shares such as real estate investment trusts (or REITs), which are often also considered a good inflation hedge, tend to act very much like other shares and so may not provide any diversification benefit. Index investors should already have some exposure to REITs through tracker funds anyway.

Given these trade-offs, and the difficulty of predicting if and when higher inflation will take hold, it is worth remembering our core investment principle of having a balanced portfolio that you stick with over the long term. Having a portfolio that is diversified across assets and sub-assets (such as different stock-market sectors and regions, or different maturities and types of bond) should mean you are not overly exposed to any one asset if higher inflation does return.

 

1 Consumer Prices Index (CPI), June 2021, Office for National Statistics.

2 Vanguard mid-year economic and market outlook 2021. Forecasts were derived from the Vanguard Capital Markets Model (VCMM) on 31 May 2021. The projections or other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from the VCMM are derived from 10,000 simulations for each modelled asset class. Results from the model may vary with each use and over time.

3 From reflation to inflation: What’s the tipping point for portfolios? Vanguard Research, May 2018.

Investment risk information

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

Past performance is not a reliable indicator of future results.

Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.

Some funds invest in emerging markets which can be more volatile than more established markets. As a result the value of your investment may rise or fall.

Investments in smaller companies may be more volatile than investments in well-established blue chip companies.

The Vanguard LifeStrategy® Funds may invest in Exchange Traded Fund (ETF) shares. ETF shares can be bought or sold only through a broker. Investing in ETFs entails stockbroker commission and a bid- offer spread which should be considered fully before investing.

Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds.

The Funds may use derivatives in order to reduce risk or cost and/or generate extra income or growth. The use of derivatives could increase or reduce exposure to underlying assets and result in greater fluctuations of the Fund's net asset value. A derivative is a financial contract whose value is based on the value of a financial asset (such as a share, bond, or currency) or a market index.

For further information on risks please see the “Risk Factors” section of the prospectus on our website at https://global.vanguard.com.

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