As I write this, the Russia-Ukraine conflict continues with its social and economic effects felt worldwide, driving investors to seeking answers to what it means for them, especially with the rising inflation concerns.
In this environment, investors’ first instinct is to take money out of the markets. Indeed, client activity we are seeing since the start of the year suggests this narrative is winning to some degree. In times like these, it is important not to lose sight of the long-term investing principles learnt from decades of financial history.
One of the lessons is that if you are really worried about inflation, the worst thing a long-term investor can do is sell out of equities or private assets as these are the primary assets likely to protect against inflation in the coming decade. The question then would be, how do we position ourselves?
The first step is to put a plan in place. For most affluent or emerging-affluent investors, the number one goal of an investment plan – after taking out insurance policies to help provide financial coverage in the event of death or health issues – is to prepare for retirement. The challenges with this process are huge. Generally, in life, the longer you are trying to predict into the future, the less confidence you have in those predictions.
Factor in inflation
If that is not enough to worry about, inflation needs to be taken into account, especially when it comes to such long-term horizons. While inflation has become more topical in the past 12 months - as gains in annual consumer prices soared to the highest level in 40 years - the truth is that the impact of inflation is generally under-estimated because you cannot see it on a day-to-day basis.
Against this backdrop, most financial asset classes, except for cash and deposits, have delivered returns that have retained purchasing power. Global equities and private equity have led the way, delivering an annualised return of 8.5 per cent and 13.6 per cent, respectively, in the 10 years to September 2020, handsomely beating inflation. Bonds have also done well since the early 1980s as central banks declared war on inflation and structural disinflationary pressures kept the downtrend on interest rates and bond yields intact.
Don’t go by the past alone
Of course, history can be misleading when we are more concerned with the future. We believe it is getting harder and harder for bonds to generate strong returns going forward and outpace inflation. Lower starting yields mean that bonds will likely lose purchasing power for investors, even assuming inflation normalises back towards 2 per cent.
Even higher yielding, or sub-investment grade, bonds are expected to return just over 2 per cent per annum over the next seven years. Therefore, we believe investors will need to have an alternative plan when it comes to keeping up with, let alone beating, inflation.
The ultimate hedge
We have some good news. First, we expect equities and private assets to continue to provide a good hedge against inflation in the coming years. Second, in financial markets, the longer your time horizon, the greater the confidence you can have in the expected outcome – while you will get a wide range of forecasts for returns over the next 12 months, longer term returns expectations are usually relatively similar.
Finally, long-term expected returns have generally proven to be reasonably accurate and therefore can be used as a decent yardstick when it comes to planning. The second and third factors are often not widely known, which is probably why most people find it so challenging to plan for the longer-term and instead commit to investments for the short-term.
What the above analysis also shows is that future returns are likely to be lower than those in the past decade. This makes it even more important for investors to focus on building foundation allocations centred around global equities and private market assets.
Thus, short-term weaknesses in equity markets, such as the one we are experiencing, should be used as an opportunity to increase exposure to equities where appropriate. There are still several investors who have excessive cash holdings or are too reliant on bond investments.
If this remains the case, I believe it would be a major contributor to people losing their purchasing power to inflation and not achieving their financial goals. Meanwhile, if an investor is inclined towards short-term opportunistic trading, I believe it should be limited to a smaller portion of the overall portfolio.
Such a holistic approach to investing has been a time-tested way to secure your financial future against the vagaries of war and inflation and whatever else life throws at you.