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Inflation: Going down the path of devaluation

December 29, 2020

reading time: 5 minutes

by Thomas Wille, LGT

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On Monday morning, the CEO of Centralsoft, a company with global operations, comes into the office and announces a two-percent wage cut – not only for the Swiss branch, but for the entire company. The employees present for the announcement react with feelings ranging from incomprehension to fear and indignation – for some, the announcement even gives rise to aggression.

Change of scene: at the monthly press conference of the European Central Bank (ECB) in Frankfurt, President Christine Lagarde announces with pride and confidence that the monetary easing measures are steadily taking effect and that the eurozone will successfully enter into a period of reflation in the foreseeable future. In concrete terms, this means that the central bank will finally achieve its inflation target of two percent. Relief is felt in the capital markets and share prices around the world trend strongly upwards.

Creeping devaluation
In both cases, the consequences for savers will be that they have less money in their wallets. In the first case, they are outraged because the news has been communicated to them directly and clearly. In the second case, market participants are jubilant. Few realize what an inflation rate of two percent actually means in the medium to long term.

If the inflation rate is positive, people lose purchasing power and can no longer buy the same basket of goods with the same amount of money. The two percent seems low if looked at on an annual basis, but over ten years it amounts to an inflation rate of 22 percent and after 20 years, of almost 50 percent. So what happens if, due to the inflated financial system, the G4 central banks’ target inflation of two percent is exceeded or even worse, becomes difficult to control?

The fear of too much inflation
The higher the rate of inflation, the more palpable the devaluation of money becomes and the more painful the consequences for savers – and this despite the fact that we are only considering rates of three to seven percent, not double-digit rates or hyperinflation.

Because of the compound interest effect, devaluation over the years would be enormous even at single-digit interest rates. At five percent, purchasing power would shrink to 62 percent over ten years.

So what can savers or investors do to at least preserve their assets in real terms?

The good and the bad inflationary environment

Generally, an inflationary environment is considered “good” when real purchasing power can be maintained or increased. The key factor here is wages, which should rise at least to the same extent as the inflation rate. However, this has not been the case in recent years. In the US, for example, the majority of employees have had to accept a wage cut in real terms. When the inflation rate rises faster than nominal wage growth, this naturally has negative repercussions. So what can savers or investors do to at least preserve their assets in real terms?

Real capital preservation: a long-term challenge

At today’s interest rates, traditional savings accounts and bonds are absolutely useless for real capital preservation. Over an economic cycle, equities generally offer a good opportunity to generate a positive real return. However, inflation must not be too high, otherwise the rising rate of inflation will have a negative impact on corporate profit margins, causing share prices to fall. The strong price gains seen in recent years alone mean that preserving capital in real terms through equities is challenging.

Gold offers a second possibility to preserve capital. Although it generates neither interest nor dividends, gold has historically served as a good hedge against inflation. This holds true especially in an environment where real interest rates are falling.

Thomas Wille: traditional savings accounts are useless for real capital preservation
Thomas Wille: traditional savings accounts are useless for real capital preservation

Inflation destroys purchasing powe
Inflation is a factor that continuously reduces the value of money, be it in people’s wallets or their savings accounts. Purchasing power therefore decreases incessantly. In today’s environment created by the G4 central banks and characterized by a highly inflated financial system, preserving capital in real terms over the long term therefore remains a challenge.

This article was first published on LGT’s finance blog, which will be discontinued in the first quarter of 2021.

 Pictures: titlephoto: Shutterstock; portraitphoto: Nadia Schärli

Investment Strategist

Thomas Wille holds a master’s degree in finance from the University of St. Gallen and has more than 20 years of experience as a fund manager and investment strategist. As Head Research and Strategy, he has been responsible for the investment strategy and the House View of the LGT private banks in Europe since 2016.

 

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