By Jason Hollands

I HAVE long thought of inflation as a silent assassin, a malevolent force that quietly eats away at the real value of your hard-earned cash, reducing its future spending power.

Yet a whole generation of savers and investors have not had to give too much thought to inflation, which has been something of a side-show since the global financial crisis.

Over the last decade price rises across many goods have been kept in check by the forces of globalisation as China has become the world’s major low-cost manufacturing hub and the rapid growth of online retailing has kept distribution costs down too. Energy prices, a key component of inflation baskets, have also been suppressed by the waning influence of the OPEC oil cartel thanks to the rise of the US shale industry and shift towards alternative energy.

Yet, more recently, inflation is the talk of the town again. The massive fiscal and monetary stimulus programmes put in place to support economies during the pandemic, combined with the release of a wall of pent-up savings accumulated during a year of restrictions as economies reopen, are sparking inflation as economies sharply rebound but consumers and businesses are confronted with supply chain bottlenecks.

Since the start of the year, many commodity prices have indeed surged higher, with Brent Crude oil soaring to $70.53 this week having plummeted as low as $19.33 in April last year. Copper has recently hit its highest price in a decade.

The evidence of rising inflation is there in plain sight. In the year to April, US consumer prices rose 4.2 per cent, much higher than had been expected. While inflation in the UK is more subdued and currently still below the Bank of England’s long-term target rate of 2%, Consumer Price Index inflation rose to 1.5% in April, up from 0.7% the previous month, on the back of higher energy prices.

Much of the surge in inflation is to be expected, given the low starting point of a severe global recession 12-months ago. The debate is whether this proves to be a temporary blip or the start of a bigger problem of persistent, higher inflation if economies are allowed to overheat fuelled by massive government stimulus packages and continued record low interest rates.

The pandemic has also compounded scepticism toward China and its trade practices, as well exposed the fragile nature of global supply chains, so the high point of globalisation and its deflationary influence appears to be in the past.

A period of higher inflation could squeeze many households, especially those that have been impacted by reductions in income as a result of furlough, unemployment or pay cuts. In other cases, however, the excess savings accumulated during the pandemic as people have stayed at home will help offset a financial squeeze.

Those with savings and investments should give careful consideration to the impact of rising inflation too. Getting a return that at least keeps pace with inflation, really should be a top priority.

Many people hold far too much in cash deposits, earning little in the way of interest. With inflation rising, it is worth considering whether your mix between cash savings and longer-term investments is right.

While it is wise to hold some cash savings for short-term needs and unforeseen emergencies, amassing a vast cash war chest that will be left untouched for several years may feel like a financial comfort blanket but, in truth, it provides a false sense of security as the real value will be eroded by inflation over time.

Government bonds, while considered “safe”, also offer few attractions in period of rising inflation. Ten-year gilts – bonds issued by the UK Government – are currently providing a meagre yield of 0.82% and are therefore negative in real terms when consumer price inflation of 1.5% in taken into account.

In contrast, UK equities are yielding 3.2%, comfortably ahead of inflation despite a very painful period in 2020 when many businesses scrapped or cut dividends as the pandemic spread.

The good news is many of those businesses have now resumed pay-outs and as companies rebuild profits, UK equities have the potential for both capital return and rising pay-outs.

In fact, dividends are the magic ingredient in delivering inflation-busting returns on equities over the longer-term.

Looking at the last 30 years, just over 75% of the total real return from the UK equity market came from the effect of dividends and the discipline of reinvesting them.

The process of reinvesting dividends, so investors make returns on them as well as their original investment, is known as “compounding”.

Nobel Prize winning physicist Albert Einstein famously referred to compounding as “the most powerful force in the universe” and the “eighth wonder of the world”.

Alongside equities, other asset classes that can help keep you ahead of inflation include higher yielding corporate bonds, index-linked bonds and infrastructure investments.

Some older readers may recall the rampant inflation of the 1970s and early 1980s and might wonder if we could end up heading back to those dark days. We are a long way off that scenario but over the medium term we could see CPI inflation in the 2-3% range.

This isn’t something to lose sleep over, but is something to prepare for, so take some time to reassess whether you have the right balance between cash savings and investments and,

in respect of the latter, whether there are steps you might take to give you the best chance possible to keep one step ahead of the silent assassin of inflation.

Jason Hollands is a managing director of Tilney Smith & Williamson.