If your pay, pensions and investment returns were all perfectly indexed to general inflation, would you care much what happened to prices? Imperfect indexation to, or compensation for, inflation is one of the biggest risks individual investors face. How do you improve compensation and can you do so enough to stop worrying about a new, more inflationary economy after Covid and after QE? You can, but for most people it will require changes in how they invest: both what they invest in and how they manage those investments.

At Fowler Drew this is not just a topical question, posed only now because a long period of very low prices looks like it might give way to higher and less stable inflation. Our entire investment approach is designed to avoid or minimise exposure to inflation uncertainty, or bets on what will happen to inflation. At all times.

This has two compelling reasons:

  • Public markets have a bad record of anticipating what the inflation regime will be and how and when it will alter
  • Inflation risk does not bear any systematic reward: errors in implied or expected inflation can be helpful or harmful to an investor’s real returns but with no trend of ‘net helpful’.

Compare this with equity real returns. Investors are also bad at foreseeing future equity returns and make mistakes in both directions. Yet that uncertainty or risk is rewarded by a systematic return or risk premium. That systematic return therefore forms the bedrock of controlled or managed exposure to capital-market risk. It is implicit in actuarial assumptions underpinning institutional investment and it shows in the FCA-prescribed illustrative growth rates that retail investment product providers must use.

If we thought of ourselves as navigators (no analogy is perfect), we could view the equity return trend as like a tide or wind we could harness to power us, alongside the equipment we need to avoid being knocked off course or destroyed by variances in wind and tide. Inflation is not like that. There is no predictable or reliable trend. Changes in direction or force are typically therefore modelled by economists (and HM Treasury) as entirely random processes, known as ‘regime switching’.

Investors alive today have experienced either one or two big inflation regimes, each very different from the other and both very different from the past. Post-war inflation, unusually consistently positive but also tending to increase gradually, peaked in the early 1980s and gave way to a prolonged phase of moderating inflation, albeit rarely negative. The changes in the rate of change were similar and neither of these phases was marked (with hindsight) by a high degree of variance. Predictions extrapolating from within each regime turned out to be fairly accurate most of the time. But actual predictions were not based on extrapolation: many more changes in regime were anticipated, perhaps as a response to governments’ interventions, than actually occurred. Outcomes were worse, for longer, than markets expected and then better, for longer. As to the switch in regime itself that did occur in the 1980s, that was far from being foreseen or even recognised at the time.

Short-term predictability was also not available historically. In earlier centuries, general price variance had neither a positive nor negative trend or bias. If anything the prevailing rate over windows of a few years or a decade is best explained by wars and weather, both being more random than predictable. With an expected mean or trend of price change of zero, long-term investors saw no need to differentiate between nominal and real investment returns.

This history lesson leaves you with a clear choice: make inflation bets and hope to make them better, or avoid making them at all. We chose to avoid them. There was no reason other than ignorance or folly to believe we could make them better.

That’s not say we’re not interested in speculation about the future inflation regime: that would be to disengage unrealistically with public-policy debate, or even academic debate. I recommend, for example, the new book from Professor Charles Goodhart cowritten with Manoj Pradham, titled The great demographic reversal and subtitled Ageing societies, waning inequality and an inflation revival. But I recommend it for interest, not action. If you want to reflect on the diversity of opinion, try The Inflation Myth and the Wonderful World of Deflation by Mark Mobius.  But I do recommend engaging with the debate on the nature of money, contextualised today as either ‘Modern Monetary Theory’ or ‘the Magic Money Tree’, depending on whose side. This has to be hugely relevant to the possible impacts on inflation of public debt post-Covid and post-QE. Modern Monetary Theory and its critics, a collection of economists’ essays edited by Edward Fullbrook and Jamie Morgan, is a good start as it aims to be neutral.

Meanwhile we get on with the job of managing private wealth with minimum exposure to inflation bets. Here’s what’s in our toolkit:

  • We model private client goals in real terms without needing to make inflation assumptions
  • We convert returns into outcomes: real spending probabilities in every year of a plan
  • We can do that by modelling real equity returns directly from deflated return time series for ‘total return’ from representative indices (by country or region)
  • We can also do that by combining equity exposure with either cash ( for the nearest consumption horizons) or duration-matched index linked gilts with known real returns (for medium-term horizons)
  • For longer consumption horizons where we are exposed to equity we are also exposed to global businesses’ ability to adapt to and pass on the inflation variances they experience – because that ability is all captured in the historical, real return, time series
  • We embrace foreign currency risk in the equity component of the portfolio because any differences between inflation in one country and inflation in the UK will tend to be reflected in currency movements (purchasing power parity works over the consumption time horizons that matter most for portfolio outcomes).

What is conventional wealth management doing differently that leaves it exposed to unrewarded inflation bets?

  • It doesn’t match the duration and nature of the client’s liabilities (usually real spending) to specific assets
  • It holds a broadly static portfolio that is constructed to maximise nominal returns for a target level of short-term volatility – which it is forced to do if the assets and liabilities have no, or only broad, time horizons associated with them
  • That risk/return trade off relies mainly on the changing mix of equity (and equity-like) assets with nominal bonds, which is why terms like 60:40 are so widely used to differentiate portfolios, funds and benchmarks
  • Managers are then limited to shortening the duration of the bonds if they want to reduce inflation exposure, which is going on a lot at the moment but is an admission of failure of the general approach to portfolio construction.

Why the difference?

  • Scale efficiency helps explain the industry’s preference for a small suite of volatility-differentiated products: it allows for maximum standardisation consistent with requirements to be seen to be making portfolios personally suitable
  • That product suite also means the industry can take in all or most of a client’s financial assets, maximising the base number to which their asset-based fee attaches
  • The richer asset mix associated with the constant search for illusive diversification benefits attracts higher fees that mainly appear to benefit the industry, not the investor
  • The investment industry is notoriously slow to adapt its thinking and its processes, partly due to the economics of embedded processes (change costs money and brings implementation risk) and partly through arrogance (its boundless intellectual curiosity is rarely turned to itself)
  • There have been no external agencies for change in retail investing comparable with the changes in pension accounting that led occupational pension schemes to reject conventional balanced management in favour of liability-driven techniques.

Experience the difference for yourself by test driving our goal planning engine for a spending goal, here.

You will see a requirement to input your needs and wants in real terms, whatever happens to inflation, but you won’t see a requirement to make an inflation assumption. The outputs are ranges of possible real spending outcome year by year, together with the changing nominal return volatility at different stages of the plan. You will have to make your own trade off between real outcomes when you need the money and volatility along the way: there is no magic bullet to give you good outcomes and a smooth return path, even if the industry would have you believe there is.