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  • Writer's pictureInvestment Synergy Team

Get set for the squeeze as a decade of financial repression looms....

Savings could be savaged as central banks all prepare for higher inflation in a bid to cut huge government debts

Economies around the world have seen an unprecedented amount of support from governments and central banks because of the pandemic.

The total amount pumped into the United States stands at about $5 trillion (£3.5 trillion). In the UK, that figure is about $500 billion and equates to 17.8 per cent of UK gross domestic product (GDP), according to the data company Statista.

This pushed the debt-to-GDP ratio up to 98.5 per cent by April, from 84.5 per cent before the pandemic.

When debt levels reach such heights, economies normally try to pay off this debt. That is what Britain has been trying to do since the last financial crisis.

After the Covid crisis, however, it looks likely that governments will continue to spend as they try to reach net zero, replacing ageing roads and improving infrastructure. And this could have a significant impact on how we approach our saving and investing over the next decade, particularly if it leads to greater inflation.

All this spending should be positive for economic growth, but it could keep debt high and climbing.

Inflation will be the weapon to keep this under control — and that could lead to a sustained period of what economists call financial repression, where price rises are higher than the growth in savings rates.

While this would be bad for consumers, for governments it could provide a way out because it allows them to borrow at levels well below inflation, meaning that they can spend more than they otherwise would or pay down their debt more quickly.

“It can be highly toxic for savers,” said Rob Morgan, an investment analyst at the fund manager Charles Stanley Direct.

“Financial repression means that interest rates on savers’ cash lags inflation, reducing spending power over time. Financial repression to some extent is a necessity as it is probably the least painful way out of the large debt burdens across the western world.”

Consumer prices are already rising steeply on a yearly basis. In the US, prices were 5 per cent higher this May than last May. In the UK, the corresponding figure was 2.1 per cent.

For now, central banks are confident that this inflation spike will be transitory and pass quickly.

They believe that because oil prices were much lower — at one point negative — this time last year and non- essential shops were shut that this is being factored in to the current figures and as a result the price rises will fizzle out in six months’ time.

But what if they don’t? The Bank of England estimates that households are sitting on a £1.6 trillion, having had little to spend their cash on. Now shops, bars and restaurants are open, so-called revenge spending, after a period of constraint, could outstrip supply and cause prices to rise.

With the retail, travel and leisure sectors reopening fast, they’re back to hiring workers and it’s proving difficult on both sides of the Atlantic. This could mean wages rise too. Many economists who first thought that inflation would be short-lived are now starting to think it could be more sustained.

“A year ago, businesses were planning for Armageddon and today some have never had it so good,” said Duncan MacInnes, co-manager of the Ruffer Investment Company. “On-the-ground experience is instructive: my barber has become 50 per cent more expensive; a pint of beer now costs me £7.80; I know a builder stockpiling materials worried he can’t get the right kit; and used car prices are at all-time highs.

“Companies cannot get staff and wages are being forced up. McDonald’s is even paying candidates just to show up for interviews. Shortages are a key sign of inflation.”

MacInnes thinks the rise in inflation figures could well be temporary. But if that is met with more stimulus, the inflationary burst could be “the starting gun”.

“We don’t expect inflation to go up in a straight line, but the direction is clear. A once-in-a-generation transition into a world of higher inflation and inflation volatility is under way,” MacInnes said.

This wouldn’t be good for savers because is it likely to mean that savings accounts and cash Isas would fall even further behind inflation, locking in huge losses for millions.

In fact, higher inflation will erode the return on any product that offers a fixed payout. These can include conventional bonds, where interest payments are at a fixed level, and annuities, which provide the retired with a fixed income every year.

Fixed rate savings accounts, which pay 1.12 per cent at best over two years at the moment, would be hit hard.

Financial repression is not a new phenomenon. Morgan noted that we have arguably been in an era of mild financial repression in the decade since the financial crisis. In the past ten years, inflation has consistently outpaced the return offered by most short-term savings accounts.

If inflation spirals out of control, then central banks will have little choice but to raise interest rates. However, if inflation settles slightly above their 2 per cent target, it’s likely to be tolerated as a way of helping with the debt burden.

“At a fairly modest rate of 2.5 per cent a year, a basket of goods and services that costs £100 now will cost £128 in ten years’ time,” Morgan said. “If you aren’t earning returns on your savings and investments over and above the rate of inflation, your wealth is going backwards.”

That’s a problem for UK savers, who generally remain wedded to cash savings. Almost two thirds of households plan to keep the cash they’ve saved through the pandemic in a bank account, according to Bank of England research.

Some 9.7 million cash Isas versus 2.7 million stocks and shares Isas were opened in the 2019/2020 tax year, HMRC said. “This might not be the wisest thing to do if financial repression does persist,” Morgan warned.

Of course, it makes sense to leave part of your savings in cash. The general rule of thumb suggests a rainy day fund of six months’ worth of outgoings. If you’re saving for short-term goals — generally within the next five years — then cash will probably be more appropriate than riskier assets.

The first consideration often advised - would be simply to ensure you pay your taxes and “make best use of your tax-free allowances, in terms of ISA subscriptions, pensions, gifting, inheritance and dividend allowances”.

Over and above that, for long-term goals more than five years down the line, moving excess savings into investments makes sense.

Also periods of financial repression can push people into higher potential returns through higher-risk assets than they would otherwise have exposure to such as simple and diversified set of investments comprising high-quality companies, alternative currencies and gold, longer dated inflation-linked government bonds and select residential and commercial property exposure should suffice.

Investment Synergy - beat potential repression.... by making sure your returns overcome the effects of inflation

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