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The cost-of-living crisis explained: how is it impacting your investments?

This article explains what the cost-of-living crisis is, how it has come about and the impact it is having on savings and investments.

Published on 08 Dec 20229 minute read

Written by Tom White

The cost-of-living crisis is inescapable. If you’ve shopped in a supermarket or opened an electricity bill lately, you will have noticed that things simply cost more than they used to. And if you’ve checked your wage packet lately, you’ll probably have found that it isn’t going up anywhere near as quickly. Even if you haven’t, the striking rail and postal workers certainly have.

And that, broadly, is what the crisis is about - prices are going up faster than wages. The chart below shows the growth in wages versus the inflation rate over the last 10 years. Over most of the period, wages have beaten inflation, leaving households wealthier. However, over the past year, average wages have risen by 6.0% compared to inflation of 11.1%. This means that in real terms – after inflation – the average worker’s pay packet has dropped 4.6%. Consumers have lost a chunk of their spending power.

What is causing persistent price rises?

As the chart above shows, wages growth has picked up since the pandemic. With skill shortages across the economy, employers are having to pay up to retain the best staff. But inflation has seen a far bigger rise. Initially it was dismissed as a blip, a temporary mismatch between supply and demand as businesses struggled to cope with the economic bounce back following the pandemic. But price rises have persisted.

There are a number of reasons for this. The war in Ukraine caused a spike in commodity prices, particularly for oil and gas and hence petrol and electricity. This has had a significant impact on inflation both here and globally.

However, there are a number of causes that are more domestic in nature, leaving the UK with higher inflation than many comparable countries. The Government and the Bank of England kept fiscal and monetary policy looser for longer than necessary once it was apparent the economy was bouncing back, adding fuel to the economic fire. The weakness of sterling, particularly against the dollar, also means we’re having to pay more for imported goods.

What will the effects of high inflation be?

It’s worth noting that this has happened before. You can see this in the chart below, which shows inflation-adjusted wages (in 2022 pounds) since the start of the century. Wages rose steadily in real terms from 2000-7, but then peaked at the time of the financial crisis and steadily fell from 2008 to 2014. They recovered subsequently, but their recent falls mean that, astonishingly, the average real wage in the UK is below where it was in 2007.

The earlier period of falling real wages serves as a good guide as to the likely effects this time.

One of these was the rise of ‘trading down’ – spending on the same goods or services, but moving away from more expensive brands. Notable beneficiaries were Easyjet and Ryanair, as holidaymakers realised that by putting up with slightly less comfortable seats they could get to the same destinations for much lower prices. The period also saw the rise of discount supermarkets at the expense of more mainstream supermarkets such as Tesco.

However, the difference this time is that the worst price rises have been in energy and food, both of which have few alternatives. Those who have already turned down their thermostats and switched to the likes of Aldi or Lidl might have nowhere further to go.

The decline in real wages from 2008-14 also provided a tailwind to nascent technological trends. The move to online shopping was partly driven by cost-conscious consumers shunning more expensive high street shops, and those same consumers also flocked to the ‘free’ entertainment provided by social media.

These trends were boosted by the growth of smartphones and home broadband. While these are now fairly ubiquitous, we should expect technological change to continue apace.

The impact on portfolios

Investing itself is one possible way to protect your savings against the ravages of inflation. The strong returns from markets in recent years mean that many have grown their portfolios regardless of what has happened to their pay packets. However, it’s important to distinguish between absolute and real returns, particularly when inflation is as high as it is now.

The chart below, which shows returns from different asset classes before and after inflation, helps illustrate this. The different characteristics of asset classes, including how they are affected by inflation, mean each could have a role to play in a portfolio.

  • Cash – few will have failed to notice the miserable interest rates available since the global financial crisis. They lagged inflation even when it was low, so holders of cash have consistently lost spending power over the last 10 years.

    Savings rates have spiked up this year to more attractive levels. However, inflation has spiked up more, so cash balances are still falling in value in real terms. This is why – aside from emergency funds – holding too much cash over the long term can be detrimental. Cash can also be a useful place to hide in the short term, providing so-called ‘dry powder’ to be deployed in higher-return asset classes when better opportunities arise

  • Bonds – they tend to suffer when inflation rises. The income they pay is fixed when the bond is issued, so inflation eats into the value of that income in real terms. They also suffer when central banks then raise interest rates to tackle the inflation. Both have happened this year.

    However, the price falls mean that, after years in the doldrums, bond yields have risen to increasingly attractive levels. While they’re still below the rate of inflation, if price rises moderate, bonds could deliver stronger returns
  • Infrastructure – this has moved from a fringe asset class to the mainstream in recent years. It has a number of attractive attributes, one of which is typically offering some shelter from inflation. This is because the underlying assets – things like bridges, roads and wind farms – often have contractually secure returns, linked to retail prices.

    Infrastructure is generally accessed by listed investment companies, so share prices can still suffer in turbulent markets. However, it can bring valuable resilience and diversification to a portfolio, qualities that have been demonstrated this year. Funds specialising in renewable energy have done particularly well, as the energy crisis and record-breaking summer temperatures have re-emphasised the need to move away from fossil fuels

  • Equities – over the long term, equities have proved a great way to beat inflation – the historical returns of equity indices have been well above retail price rises, and companies can often raise their profitability simply by putting up prices. However, over the short term they can definitely take a clobbering – equities are volatile, after all - and this year’s market falls look even worse when adjusted for inflation.

    Volatile markets make it scary to invest – it’s easy to extrapolate from 2022 and assume 2023 will be equally bleak. That might be the case, but often the best returns come when the headlines look worst – think of March 2009 at the depths of the financial crisis, or March 2020 as we entered the pandemic. Equities have proved their worth against inflation over history. However, their short-term returns are difficult to predict, so they should definitely be thought of as a long-term investment.

    Investors looking for a specific edge over inflation might look to favour higher quality businesses with pricing power – those with brands or technological edges that mean customers will pay a premium to stay with them. Energy companies are another area that could be attractive, with higher oil and gas prices seemingly here to stay

Don’t forget the lessons of the past

With markets turbulent there have been few asset classes that have delivered positive returns this year, and fewer still that have beaten inflation. However, that doesn’t mean we should forget the lessons of the past.

We believe the best way to conquer inflation is to invest much the same as always: to invest in a diversified portfolio of assets that suit your circumstances and, despite their recent woes, not to forget the long-term potential of equities. This doesn’t guarantee success – we’re dealing with probabilities, not certainties ­– but it can help tilt the odds in your favour.

How to cope

The internet abounds with tips to reduce your outgoings, from insulating your property to renegotiating your mobile phone contract. As an investor there is also a lot you can do to reduce costs on your investment portfolio. If you’re not already with a low-cost platform such as Bestinvest, switching can help you reduce fees. Bestinvest has service fees from as little as 0.2%, it doesn’t cost anything to buy and sell funds and you can trade shares for just £4.95 a trade.

There are also measures you can take to cut costs within your portfolio. One is to move into cheaper funds. Index funds are an obvious example – funds such as Fidelity Index UK or Vanguard S&P 500 UCITS ETF are available with annual charges of less than 0.1%. Charges for active funds vary too - Scottish Mortgage Investment Trust has an annual charge of just 0.32%, less than half the cost of many rivals But it’s important to remember that cheaper funds might be a false economy if they deliver poor performance.

Bestinvest also has a range of Ready-made Portfolios including our ultra-low cost Smart range for those that would rather not choose and manage their own investments.

Important information

By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.

The value of an investment may go down as well as up and you may get back less than you originally invested.

Past performance is not a guide to future performance.

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