If you must fear, don’t fear the stock markets … fear inflation

It has been said that we are each separated from any other person on earth on average by six steps (referred to as ‘six degrees of separation’). This has recently been challenged by Adam Gordon of Gordon BDM Ltd, a business development and marketing specialist based in Scotland, who maintains that with the advent of social media we are all much closer than ever before.

I realised the truth of this yesterday when Elizabeth Emanuel, fashion designer and co-designer of Princess Diana’s wedding dress, started following my tweets (my Twitter account is archmoneyguide). Last evening I was having dinner with ten or so fellow IFAs and Bill McQuaker, Deputy Head of Equities and Head of Multi-Manager at Henderson Global Investors. Bill told us that he had recently had dinner with a dozen or so, mainly UK, fund managers and Angela Merkel, Chancellor of Germany was their special guest. Dr Merkel (she was awarded a doctorate for her thesis on quantum chemistry) is currently the longest serving leader of a G8 country and arguably the most powerful person in Europe and I was only two degrees of separation from her!

Bill McQuaker’s meeting with Angela Merkel clearly left an impression on him as she had addressed the small lunch gathering via an interpreter for well over an hour. Whilst it was not his place to share with us the content of that meeting I think it is fair to say that he is expecting markets to continue having a rough time of it well into 2012. On the other hand he is positioning his portfolios so that they can react quickly to any unexpected good news.

2011 so far

Bill McQuaker talked to us about global market returns for the year to 15 November 2011. To no one’s surprise the big losers had been equities with Europe ex UK leading the way at -15.3%. However, it was perhaps surprising to note that Emerging Markets were -14.5%, Japan -14.1% and Pacific ex Japan -10.9% so simply avoiding European equities was not a solution. Whilst the UK was -4.4% the other surprise was that North America was -0.6% and easily the best equity market to have been in this year. Sadly, so many investors have written off the US and moved their money elsewhere.

The surprise winners this year have been bonds which, in theory, do badly in times of rising inflation. Long term gilts (over 15 years) returned an amazing 24.3%, index-linked gilts returned 15.4% and all gilts on average returned 14.2%. Corporate bonds which are normally riskier than gilts (although some would say that Tesco is now less likely to default than some sovereign states) returned 7.1%.  Of course, the big story of the year has been gold returning 25.3% and more worrying for the recovery of businesses, oil returning 21%.

The danger for investors is to see those returns from gold and gilts and think that these offer a safe haven in troubled times. With both returning around 25% this year to date prudent investors will remember that it is not good practice to purchase anything when its cost has risen out of proportion to other items.

Can the debt crisis be sorted?

It is, of course, difficult to give a definitive answer to this one. Dr Merkel is clearly struggling to find a solution. One point that Bill McQuaker was keen to make is that whilst Europe has a lot of debt it would be wrong to assume that it was going bust. Europe is one of the richest areas of the world. Apparently it would only take around 4% of Europe’s wealth to completely remove all of its indebtedness, it is just that no one wants to take the loss.

Bill McQuaker suggested that the solution was there for us all to see in history. After the First World War the victorious nations decided to punish Germany and the result of the enforced austerity was a generation prepared to be led by Hitler. After the Second World War the US in the form of the Marshall Plan (officially the European Recovery Program) decided that things were in such a mess in Europe that they would have to help Germany in particular to recover for the sake of the whole of Europe. At present the stronger European economies are tending to punish those like Greece and Italy who appear to have lost the plot. Instead, slashing the indebtedness of those countries most in trouble and then increasing trade with them would share the pain around but would, in the end, build a stronger, more united European economic community.

Inflation is the real problem

The Consumer Prices Index (CPI) is currently 5.0%, more than twice the Government’s target of 2.0%, whilst the Retail Prices Index (RPI) is 5.4%. MetLife has recently given the example of a 60 year old taking a £6,180 annual income from a £100,000 pension fund. Assuming inflation of just 3.45% pa over the next five years will see the real value of that pension fall to £5,216 in 2016 and £3,716 by 2026 when the person reaches age 75 – a drop of 40% in real terms.

The CPI fell from 5.2% the previous month and most commentators expect further falls between now and the end of the first quarter of 2012. However, given the amount of ‘quantative easing’ with the possibility of more to come, Jupiter income manager, Tony Nutt, has stated that UK inflation could reach 7% to 8% over the next four years. Whilst other commentators such as Henderson chief economist Simon Ward believe that to be a bold statement, he has also acknowledged that 8.0% inflation over that period is not unrealistic.

Is there any good news?

The important thing to remind ourselves about global stock markets is that they have already priced in a great deal of the mess that is happening in Europe and the slowing growth in other parts of the world. Of, course, if Greece actually defaults then the initial shock will still push markets down for a period. But much of the bad news that will no doubt keep coming for a while is expected. In such an environment any truly good news will see markets take off.

Whilst the short term is expected to be a rough one for investors we all need to be in this for the long term. In which case it is good to see that equity valuations remain supportive. The average price/earnings (P/E) valuation of the global market over the last 10 years has been 14.3 times earnings. At present the average P/E valuation is 9.9 times earnings and not much above 8.0% for UK stocks.

So whilst equities are unloved they are also undervalued. European equities at the end of September were producing an average dividend yield of 3.8%, whilst German 10 year bonds were producing a yield of just 2.1%. Taking a 5 year plus view the higher income from equities and the very much greater potential upside makes a compelling argument to stay fully invested.  Comments made by Prime Minister, David Cameron, yesterday in Parliament do not rule out a short, sharp injection of cash to try and get the UK economy moving again. Any such move would probably have the blessing of markets as cutting back on debt alone is not working.

If you must fear

If you must fear, don’t fear the stock markets, as these will provide the long term real growth that your pension funds and investments need - fear inflation. However, it is far better to live without fear. Most of us cannot remember what was worrying us six months ago as we have long since replaced it with something else. Money is a strange substance and tends to gravitate towards those who feel that they live in abundance (however little of the stuff they might actually have) rather than in an attitude of scarcity.

If you would like to discuss your investment planning please ask your usual Arch adviser or telephone 01483 204600 or email enquiries@arch-fp.co.uk.

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