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It's Time to Start Thinking in Real Terms

Updated: Jun 22, 2022

There are two effects of high inflation.

The first is one that we have in recent weeks and months become brutally aware of, namely its effect on nominal financial asset prices. Nominal bond prices get hit because their yields rise - and thus prices fall - to compensate for the higher inflation. Nominal equity prices get hit because higher inflation causes recession risk to rise, thus increasing the possiblility of a fall in corporate profits, the basis of equity values.

The second is more insidious and relates to the fact that when inflation is high, nominal returns are considerably worse in real terms i.e. when the inflation rate is deducted from nominal returns. These are what are called real returns and are important because they tell you what is happening to the purchasing power of your investments - you should also consider your salary in real not nominal terms.

I have always thought in real terms. It seems clear that the nominal value of your investments or salary is far less important than what you can buy with them i.e. their purchasing power. However, it is rarely made clear by the investment industry or by the financial media that you should always think in real terms. I'm not sure why this is. Perhaps subtracting the inflation rate from everything is just too complicated.

But there is also ignorance in play. Financial journals often refer to an exchange rate being weak or strong without taking into account what inflation is doing. If you're going on holiday to Turkey, don't get too excited about the lower foreign exchange rate - it is largely due to consumer prices in Turkey having gone through the roof in relation to prices in the UK.

Laziness and ignorance. Sigh.

Another reason perhaps for not thinking in real terms is that when inflation is low it does not impact purchasing power materially. Equities and bonds for the last forty or so years have together been returning 10%-ish per annum in nominal terms, so it could be argued the 2-3% inflation we have seen over the same period has not made too much of a dent.

However, the world has changed. Inflation is now high single digits and on average may be high for the next decade or more, thus materially reducing purchasing power. If you have not been thinking in real terms, now is the time to start.

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

© Chimp Investor Ltd

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