Inflation is coming! We’re already starting to feel it with the rising cost of petrol, fuel bills and groceries. Interest rates remain low and probably will for some time in the UK while Brexit plays out, which makes inflation a pretty sexy investment at the moment. Unfortunately, inflation is poorly understood and the assets that benefit from rising inflation are fairly scarce (inflation funds) or obscure (inflation-linked gilts).

The Bank of England’s recent Quarterly Inflation Report (video here if you can bear one hour of monotone delivery by a central banker, PDF here) shows that inflation will rise, driven largely by the fall in the value of sterling, peaking at 2.8% in 2018. This won’t be a short, sharp spike in inflation, it will be long-lived and so that means you will have time to get on board.

The uncertainty around this forecast is quite substantial, but markets agree with the Bank’s forecast, here are the fat fan charts, but the direction is not uncertain: it’s up!

That’s why we decided to dig into this topic in one of our videos where we showed which assets rise in value when inflation is high. We used some lovely long-term data from the Nobel Prize-winning economist Robert Shiller. His data goes back to the 1800s and that gives a powerful insight into asset returns in the past. For example, media reports often say that gold is a good inflation hedge: it isn’t! Historically gold returns have little to do with inflation. Shares don’t work either if inflation is above around 4% because valuations fall sharply as inflation rises, and we showed this with a scatter plot that looks rather like the Sorting Hat from Harry Potter.

When inflation is too high or too low shares in the US de-rate, which means investors are willing to pay less for earnings and price to earnings ratios (and share prices) fall. The sweet spot, the tip of the Sorting Hat, is around 3%. This is surprising because the accepted wisdom is that if raw material prices rise for companies they can pass this on to their customers by raising the prices they charge for their goods and services. It looks like that works up to a point, and the point is about 4%.

Bonds are the worst-hit asset if inflation rises because they pay a fixed income and this is eaten away by inflation. But some bonds have inflation protection built in: inflation-linked bonds. A bond is effectively just a loan you can trade, and for inflation-linked bonds the amount you are repaid and your coupon income are both scaled up by the cost of living. These can be expensive and awkward for small investors to trade so we also did a video on funds which are linked to inflation.

Value of £1000 invested in 2007 in an iShares gilt fund and inflation-linked fund

That’s a comparison tracking performance of £1000 invested in 2007 in two iShares funds. One is a gilt fund and the other is an index-linked gilt fund. In theory the inflation-linked fund should out-perform when inflation is high and that is the case. It’s clear that the index-linked fund would have been a better bet over this period rising to £1,788 at the end of January in 2017 whereas the gilt fund would have been worth just £1,294. The ongoing charges for the two UK gilt ETFs are reasonable: iShares INXG fund’s Total Expense Ratio is 0.25% per year and Lyxor’s GILI fund TER is 0.07% per year. That means that £1000 invested would cost you £2.50 per year for INXG and 70p per year for GILI.

There are a couple of risks you should bear in mind. If the UK gets downgraded, and yes that could happen, the price of these funds will be hit. And if we get deflation the price would also be hit because UK gilts don’t have an inflation “floor” built in. However deflation isn’t considered likely by the Bank of England or markets (see the fan chart above).

Hopefully I’ve convinced you that inflation is sexy – let us know!