Imaginary Curve

Ever wondered what would drop alongwith prices if the inflation rate were to plunge dramatically? How would you reinvent your investment strategy? In what way, would you have to plan for retirement? These questions may seem totally irrelevant to our economy where inflation is sure to continue to remain high but for our readers, here is a view from the other end of the looking glass.

Roger Bootles book The Death of Inflation -- Surviving and Thriving in the Zero Era, was published by Nicholas Brealey earlier this year. The information is largely apaplicable to the developed countries, in particular, to the UK but it makes for an interesting read, nevertheless. Extracted is a check-list of tips to keep you out of the financial morass as inflation plummets.

 

With inflation likely to be very low indeed, you should:

Avoid debt as far as possible: its real value will no longer be eroded by rising prices and, on the whole, your salary will no longer rise rapidly to make it bearable.

Do not be deceived by "low" interest rates into thinking that borrowing, including mortgage borrowing, is cheap. If there is no inflation, then official rates of 6 per cent will be high and borrowing rates of 8 or 10 per cent more, which personal borrowers, often pay, will be crippling.

When thinking about buying a house, discount thoughts of profit and consider only its merits as somewhere to live in the light of your circumstances. Your "investment" will probably at least hold its own in real terms over the long haul, but returns will be far from attractive. The days of automatic large profits from property are over.

If you have been counting on making enough profit on your house to provide a nest egg when you retire, or to provide a nice sum to leave to your children, you will need to reconsider your plans. You may need to save a lot more to reach your desired objective.

Beware "investments" in real assets like paintings, antiques, classic cars, fine wines, coins and stamps. It will always be possible for individuals to make money by buying particular specimens wisely but, as a rule, without inflation these assets will struggle. Think of them as things to be enjoyed for their own sake which will probably hold their value over the long term (provided you have bought them at a good price) but not as an easy source of profit.

While the financial markets are still sceptical about continued low inflation, there are attractive investment opportunities in long-term, fixed interest bonds. But since financial markets still panic at the sight of their own shadow, be prepared for a bumpy ride.

Equities almost certainly will not do as well as you are used to in money terms but they may do better in real terms. Remain highly invested but, as with bonds, be prepared for a bumpy ride.

Do not be deceived about the likely future value of your pension. As inflation recedes, the rates of return which the investment institutions can earn on your moneyfall as well. So, do not count on those annual increases of 10 per cent or 15 per cent which you had been encouraged to expect.

This does not necessarily mean you will be worse off. Indeed, you could be better off in real terms because prices are no longer rising anything like as fast as they used to. What you must avoid, though, is combining the assumption that today's prices will continue, with the notion that your pension fund investments will continue to grow by 10 or 15 per cent per annum.

Above all, try to think real. When your income is rising by only 2 or 3 per cent, that does not necessarily mean you are worse off than in the old days when you used to get 10 per cent increases every year. And, when trying to guard against the risk that prices may at some stage fall, be aware that credit risk takes on added importance: in these conditions, debt is even deadlier than ever. Avoid investments in heavily indebted companies, particularly those with a significant amount of long-term fixed interest debt.

At anything other than give-away rates, avoid fixed interest debt, including fixed rate mortgages, like the plague. If and when prices fall, variable mortgage rates will come a good deal lower.

Avoid variable rate bank and building society deposits because interest rates will probably fall to next to zero, as they have in Japan. As far as possible, put money in long-term deposits with fixed rates of interest. At least the real value of your deposits will rise under falling prices, but this makes it important that you choose your bank well. Some may find their assets severely imperilled by a regime of falling prices.

The best bet is long-term, fixed interest bonds. Even here there is a risk. You have to hold bonds issued by governments which are not heavily indebted, and particularly those which are not heavily indebted on long-term, fixed-interest bonds. For, as prices fall, the ability of governments to pay interest on debt will be impaired.

If you are retired or are about to retire, you are lucky that UK pension funds, and the legislation governing them, make no provision for pensions to be cut. So, if prices fall, pensioners could be among the winners. Again, to be secure, you need to have your pension with a provider which has its funds invested appropriately for such conditions and which can stand up to paying pensions whose real value may be much higher than originally envisaged.

There is a natural limit to how low annuity rates can fall, but it is well below present rates. Once the financial markets have adjusted to the idea of deflation, then annuity rates will plummet. If you are in a flexible position as to when you fix your annuity, you can pre-empt this prospective fall in rates by fixing now.