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Inflation falls below target

Tom Stevenson

Tom Stevenson - Investment Director

Prices are rising even less quickly than we thought. Today’s announcement from the Office for National Statistics unveiled an inflation rate of 1.8% - that’s well below last month’s 2.1% and safely below the Bank of England’s 2% target.

The main factor in this month’s drop has been lower gas, electricity and petrol prices. Household fuel bills fell after a reduction in the price cap imposed by the energy regulator Ofgem. Petrol prices reflect a lower oil price.

Inflation falls below target

The last time inflation stood at this level was two years ago in January 2017. In between it has been as high as 3.1%.

Is this good or bad news?

For the most part, we should welcome slower price growth. With the most recent household earnings data showing wages rising at 3.3%, everyone’s real, inflation-adjusted income is rising. That means we have more money left over after unavoidable expenses like the mortgage and food shopping.

A low inflation rate means that the real value of our assets and incomes is maintained for longer. Even at just 2% a year, the purchasing power of our money falls by half over a period of 36 years. Inflation is like an insidious tax - we don’t see it taken off our salary slips every month, but it is no less real for that.

So lower is generally better as far as inflation goes.

Inflation is particularly important for investors, who should always think about the value of their portfolios in real, inflation-adjusted terms.

If you retire at the age of 65 with a £500,000 pension pot, and draw an income from that at a rate of 4% a year, you can look forward to £20,000 a year.

That might sound OK today, but if inflation were to average, say, 4% a year, that level of income would have the same purchasing power of just £10,000 by the time you are in your early 80s.

A proportion of the returns you achieve on your investments (either capital growth or income) must always be used simply to offset the erosion of value caused by inflation. This is why the Bank of England is tasked with keeping inflation in check. It really matters.

Low inflation is not all good news, though. One of the reasons why inflation fell this month was a small reduction in the cost of clothing and footwear. This reflects how difficult retailers are finding life at the moment. The only way they can persuade us to part with our cash is by cutting prices. Consumer confidence is low.

In part this reflects political uncertainty as the clock ticks down on Brexit. There is also a general slowdown in economic activity around the world. Central banks are putting on ice their plans to raise interest rates as they worry about the fragility of the recovery from the financial crisis a decade ago.

If inflation stays lower for a bit longer than we thought, what does that mean for our finances? The most important implication is that the Bank of England will probably not raise interest rates from their current very low level for the foreseeable future.

This means that the returns on cash - in a deposit account, for example - will remain very unexciting. To achieve the returns needed to offset even low inflation, and then deliver some real growth as well, investors will need to take a few more risks with their money.

That means investing in higher-yielding assets like bonds and, particularly, shares.

Fortunately, shares continue to be a good source of income. The yield on the average share in the FTSE 100 index is now around 4.5% - well above inflation and much better than what you can earn from cash or the safest bonds issued by governments.

Investors can either invest directly in shares paying a high dividend or via funds which specialise in this kind of investment style. Anyone looking for funds that invest in companies paying high dividends should look out for the words ‘equity income’ - that’s the industry jargon for this kind of fund.

Our Select 50 list of our favourite funds includes several funds like this:

The Invesco Global Equity Income Fund and the Fidelity Global Dividend Fund, as their names suggest, look for income-paying shares all around the world. This has advantages over a more focused single-country approach and will suit many income-focused investors.

It’s worth remembering, too, that income funds like these can be a good source of long-term capital growth if the dividend income is re-invested. Income has been shown to be one of the primary contributors to total returns from the stock market over time.

The Fidelity Global Dividend Fund is, incidentally, one of four funds I’m recommending for 2019. These ‘Tom’s Picks’ funds reflect the views in my latest Investment Outlook, which you can read here.

Read more about all four recommended funds.

Important information

The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Reference to specific funds should not be construed as a recommendation to buy or sell these funds and is included for the purposes of illustration only. Select 50 is not a personal recommendation to buy or sell a fund. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.