A hidden danger threatens your portfolio, cautions new research.
For investors, inflation is dangerous. No matter how reliable your income stream, inflation can rapidly degrade its purchasing power. Worse, inflation can ravage the purchasing power of your capital, too.
That said, many investors -- myself included -- will feel reasonably safe in the assumption that, in inflationary times, equities are a safer bet than most other asset classes.
Almost by definition, for instance, fixed-income assets -- bonds and gilts -- will suffer. The same goes for cash savings. But with their link to the real economy, and to corporate pricing power, equities intuitively seem a better bet.
No shelter
As research by London Business School academics Elroy Dimson, Paul March and Mike Staunton highlights, that assumption holds true -- up to a point.
But their findings, published last week in the latest Credit Suisse Global Investment Returns Yearbook, are disturbing. Analysing the impact of inflation over various asset classes, and over an impressive 112 years of history in 19 countries, the conclusion that they come to is that no asset class is truly immune to the ravages of inflation.
In short, equities suffer as well -- although not as much as bonds, gilts or cash. And nor do commercial property and gold offer the protection that might be assumed.
Simply put -- and this is a simplification -- in times of high inflation, inflation-adjusted equity values go down, sometimes sharply. In times of low or modest inflation, they are more likely to hold their own, or appreciate.
Index-linked peace of mind
Over the weekend, Fidelity's Tom Stevenson wrote a thought-provoking column in the Daily Telegraph, discussing these findings.
He too, it turned out, had thought that equities would be a better buffer against inflation than the evidence suggested.
And the lessons, as he saw them, were twofold. First, don't rely exclusively on equities for inflation protection; index-linked bonds have a place in every investor's portfolio. Second, letting inflation get out of control is a very bad idea indeed.
Last night, I picked up the phone and chatted to him.
Short-term pain, long-term gain
While disturbing, the London Business School research does offer some reassurance, stressed Mr Stevenson. Look at investments that offer the prospect of an income -- unlike gold, or the house that you live in -- and equities remain a pretty decent bet.
"The research confirms the view that equities provide the best long-run return," he said. "So investors need to be exposed to equities, because that is where their returns are going to come from."
And over the long term, he added, inflation hasn't been an enormous problem. The difficulty comes during those periods, such as the 1970s and early 1980s, when inflation does get out of hand.
Which is why, he says, we should be worried about the extent of the quantitative easing that is being undertaken by the Bank of England in order to ease the credit crunch.
"People say that quantitative easing is only a little bit inflationary," he says. "But that misses the point that history suggests that a little inflation can very quickly turn into a lot of inflation."
Good news
Today's news on inflation is welcome. Inflation fell to an annual rate of 3.6%, significantly lower than the 4.2% recorded for December. Among economists, a fall of this magnitude was expected; input price pressures are slowing, and last year's rise in VAT falls out of the calculation.
My bet -- although article comments have previously disagreed with this view -- is that inflation will continue to fall, although I think that the Bank of England will struggle to get it down to very much below 2%.
But if that level of inflation can be reached, and maintained, then it's good news for equity investors.
For one of the clearest messages from the London Business School research is that during periods when inflation is moderate and stable, and not fluctuating sharply from year to year, equities have performed reasonably well.
"In such economic conditions, companies are likely to be able to make sensible capital allocation decisions, and prosper accordingly," explains Mr Stevenson.
Lurking danger
All of which says that the critical period for inflation is some way off -- mid-2013, perhaps.
If inflation can be brought down, and held down, then equity investors can be reasonably sanguine. If not, then the purchasing power of their income and capital is under threat. And, what's more, under a greater threat than many will have realised.
Here's hoping, then.
> Get the latest on investing and the markets from the desk of David Kuo -- join The Motley Fool Collective today.
More from Malcolm Wheatley:
