lemons

Inflation: lemons don’t always lead to lemonade

16 Mar 2017

Justin Urquhart Stewart, Co-founder and Head of Corporate Development

The Office for National Statistics has completed its annual review of the basket of goods that it uses to calculate inflation. But what does that mean, how is inflation calculated and what effect does it have on investments. We talk through some of the basics here.

My penchant for Sipsmith Gin and Fever Tree Tonic Water is well-known among family and friends, as well as regular readers of my many musings on the investment industry.

This year, it seems that (for a change) I am on trend – although the hipsters and I probably only concur on the gin. Sales of the stuff have shot through rooves of small-scale distilleries. Between 2009 to 2015, they rose from £126mn to £239mn a year…although I’m quite relieved that the increase is not being ascribed to my personal consumption!

But what does all this have to do with investments?

Well, it boils down to the news that the tipple has been re-added into the official basket of goods used to calculate inflation and produce the Consumer Price Index (CPI). After a 13-year absence, its spread from suburban semis to cool clubs means more of us are lingering over a G&T than for quite some time.

Changes are made to the CPI basket of goods every year by the Office for National Statistics and have been since the basket was first developed in 1947. They survey what the average UK citizen buys, ‘weight’ those purchases according to the level of actual money spent and use a formula to take into account that people will almost certainly switch to a lower priced alternative when prices rise.

The basket serves to estimate how much it costs for us to live the same lifestyle as we did in previous years, while trying to incorporate society’s vagaries.

Last year lemons were added as a separate purchase from other citrus fruit and…proving that they don’t always lead to lemonade…this year it’s gin that’s in the headlines. Also now included are flavoured ciders – not just apples and pears – non-dairy milk drinks, cycle helmets and a base layer top – whatever that might be! Other items were removed as they’re not as prevalent. So out go children’s swings, fees to stop a cheque and single sink drainers.

Once calculations are done, if the basket’s more expensive, there’s inflation in the economy. If it’s less expensive, then there’s deflation present.

But unfortunately the basket is becoming more and more expensive. Last week, the Office for Budget Responsibility – another government-funded statistical watchdog – raised its 2017 forecast for inflation from 2.3% to 2.4%, upping its November number given the pace of price rises has picked up since then. They see inflation peaking in Q4 2017 at 2.7%, before then starting to fall to 2.3% in 2018-19. It should then drop further to 2% in 2019.

As investors, we need to be aware of these facts and figures in order to understand how hard our investments need to work just to keep pace with the cost of living over the long term. Only then can you really calculate how much each ISA or pension pot is growing to meet all your long term goals and aspirations.

If you’re a multi-asset investor, you should already be benefiting from diversification. So, while your fixed income and cash investments are likely to be experiencing a negative impact from inflation, your equity investments should help balance out such losses. In general, when inflation is up, equities rise too – even if their volatile nature means you need to step back to see that longer term trend upwards.

Commodities also tend to be assets that rise with inflation. The price of goods goes up because it becomes more expensive to produce them and the cost of the raw materials has also probably gone up. However, commodities can only be appropriate for PART of a portfolio. Supply and demand play quite a part here…and have a very tenuous link with your lifestyle.

A recent investment at 7IM was to focus on inflation protection through the purchase of a specialised type of investment called an inflation swap. These effectively allow us to hold the inflation guarantee ‘bit’ of an inflation-linked bond. Inflation swaps rise in value with inflation, without this being diminished by the various dampening effects typically associated with bonds. This makes them more volatile than fixed income, but more aligned to the inflation protection that investors are likely to be seeking.

Now…my only question left to ponder is what constitutes the adult jigsaw also now included in the basket?

Justin Urquhart Stewart
Co-founder and Head of Corporate Development

Seven Investment Management LLP is authorised and regulated by the Financial Conduct Authority. Member of the London Stock Exchange.  Registered office: 55 Bishopsgate, London EC2N 3AS. Registered in England and Wales No. OC378740.

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