Our Perspective on 2022's Investment Returns
This is the fourth Collingbourne review of annual investment returns (having missed the overwhelmingly positive, if slightly dull 2021). In 2018 we looked at returns versus expectations, 2019 looked at ‘randomness’ of asset returns and in the wake of 2020’s pandemic related turbulence, we examined investor behaviour.
The main story of 2022 was without doubt inflation and the return of double-digit rates not seen since the early 1980s. As well as causing consumers no end of pain, this has been a major concern for many investors who will have seen their capital’s purchasing power eroded by a combination of high inflation and negative returns.
Source: ONS
Few asset classes came out of 2022 unscathed. Except for cash and some other esoteric options (although crypto assets were largely hammered) most major asset classes were down. In particular, Bonds, a traditional safe haven suffered their worst returns in over 30 years. We wrote an article here about bond markets - written before October’s mini-budget / pension LDI induced meltdown – discussing this issue.
How do you Protect Investments from Inflation?
It’s a question we’ve been asked a few times over the last year. In an ideal world you would have an asset that would both protect the long-term purchasing power of your capital, by increasing by above inflation (after costs and tax) but also provide low capital risk (and liquidity) in the short-term.
As proven by the large falls over the last year, Index-Linked Gilts do not provide this short-term security. It makes sense that such an asset would not exist on the open market; investors would pile money in and bid-up the price to a point where the expected return would be below inflation.
There used to be NS&I (National Savings & Investments) Index-Linked Savings Certificates which did provide this - a return just above inflation, tax-free, capital guaranteed by the UK government - but new issues haven’t been available for years. Owners of existing certificates can keep rolling them over, however.
Instead, investors typically face a trade-off between a long-term inflation hedge and short-term capital security and liquidity.
Real Assets
Certain assets can be expected to increase with/above inflation over the long-term, often described as ‘real assets’. The main types of real asset are equities (company shares) and property.
Equities: Inflation is essentially companies putting up their prices. This means that in aggregate, firms’ earnings and profits will increase with inflation over the long-term.
Property: Rental income will generally increase with inflation (subject to local supply/demand). Over the long-term we can also expect capital values to reflect this.
As you would expect, there is long-term data showing equity market and property returns (particularly on the residential side, where data sets are longer) exceeding inflation.
Lower Risk Assets
There are two main asset types which traditionally provide capital security and short-term liquidity; cash and bonds.
Cash: Fixed capital value, variable return
Bonds (short-dated): Fixed income level, variable capital value (traded on market)
Bonds typically have a higher expected rate of return as investors demand more for the longer investment term (and uncertainty over this time) but have less capital security (as seen over the last 18 months).
What if Higher Inflation Persists?
A concern for many investors will be higher inflation persisting and continuing to erode the real value (purchasing power) of their capital.
Over the short-term, this could happen. The good news is that over the long-term, the expected return on real assets is linked to inflation. If our assumption for long-term annual inflation increases, then so does our expected return for equities.
Higher interest rates also feed through to higher returns on cash and bonds – the expected return on bonds being equivalent to that on cash, plus a risk premium for the term and credit risks taken. As we wrote back in June, the falls in capital values of bonds have increased the forwards looking expected returns on bonds.
From a longer-term perspective, the real expected return on invested assets shouldn’t be heavily impacted. Inflation may increase, but so should (nominal) expected returns. Sharp increases in inflation can however bring sharp and painful adjustments to investment markets over the short-term, as we saw last year.
Summary
Unless you own old NS&I Indexed-Linked Savings Certificates, there are no assets that can provide long-term inflation hedging and short-term capital security and liquidity.
Real assets, such as equities and property can provide a long-term inflation hedge and cash and (short-dated) bonds can provide capital stability and liquidity.
Sudden spikes in Inflation can cause investors a lot of short-term pain. However, over the long-term (nominal) expected investment returns should also increase, helping to compensate for the impact of higher inflation on real values / purchasing power.
The appropriate mix of these asset classes for an investor will depend on a number of factors including; emotional risk tolerance, capacity for loss, return requirements, liquidity requirements etc.
If you would like to discuss your investments, please contact us via the button below.
Returns stated are Total Returns (including income reinvested) to 31/12/2022 of various indices representing individual asset classes. Indices are not available for direct investment and take no account of charges or tax. Data sourced from Dimensional Returns Programme.
Disclaimer:
This document should not be considered a recommendation to purchase or sell any particular investment. Care has been taken to ensure the accuracy of content, but no responsibility is accepted for any errors or omissions. We do not predict or guarantee the future performance of any individual security, investment, portfolio or asset class.
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