Does Gold Protect UK Investors from Inflation

This post is a response to the brief exchange with Faustus on the last Gold Price in British Pounds post.  Today I’d like to attempt to answer the first question which is “whether gold is really as good a hedge against sterling inflation as is sometimes suggested.”

Let’s firstly review why in my opinion it is important not to forget about the damage that inflation can do to your savings.  The Bank of England has a remit “to deliver price stability – low inflation – and, subject to that, to support the Government’s economic objectives including those for growth and employment. Price stability is defined by the Government’s inflation target of 2%.”  If January 2013 sees the Consumer Price Index (CPI) remain above 2%, and at 2.7% today I see no reason why this won’t be the case, then this will be the thirty eighth month in a row that they have missed their target.  This demonstrates that the Bank of England’s remit actually has nothing to do with the official line presented.  If it did they would have been made sacked for poor performance long ago.  I therefore take inflation seriously.

If you believe that the CPI provides an accurate measure of inflation, and had the Bank of England met their remit of inflation at 2%, then £1 three years ago would have had the purchasing power of £0.94 today.  Instead the current policy employed by the Bank of England, of keeping the patient flat lined at 0.5% combined with plenty of QE, means that your £1 actually only buys £0.90 worth of goods and services today.  That’s a 10% loss of purchasing power in only 3 short years.

I’ve already laid out some techniques I’m using to protect myself from inflation however let’s now look if gold could be added to that list for UK Investors.

UK House Value vs UK House Affordability – January 2013

This is the monthly UK House Affordability update, which is the metric that I believe is the key driver of UK House Prices.  It is also the update for UK House Value which is the metric I am using to assess when it is time to buy a UK home.  The last update can be found here.

Let’s first update the key data being used to calculate both UK House Value and UK House Affordability:

• UK Nominal House Prices.  In recent posts we have been comparing the different UK House Price Indices however for this analysis we will stay with the Nationwide Historical House Price dataset.  December 2013 house prices were reported as £162,262.  Month on month that is a fall of £1,591 (-1.0%).  Year on year sees a decrease of £1,560 (-0.9%).
• UK Real House Prices.  If we account for the devaluation of the £ through inflation (the Retail Prices Index) we see those falls accelerated.  Month on month that decrease of £1,591 changes to a decrease of £2,385 (-1.4%).  Year on year that £1,560 decrease grows to a decrease £6,625 (-3.9%).  In real terms prices are now back to those around December 2002 (from March 2003 last month). 
• UK Nominal Earnings.  I choose to use the Office for National Statistics (ONS) Average Weekly Earnings KAB9 dataset which is the seasonally adjusted average weekly earnings of both the public and private sector including bonuses.  November 2012 sees earnings at £472.  Month on month that is an increase of £1.  Year on year the increase is £7 (1.5%).  With inflation (the Retail Prices Index) running at 3.0% over the same yearly period the purchasing power of those that work continues to be eroded.
• UK Mortgage Rates.  The proxy I use to monitor mortgage interest rates is the Bank of England dataset IUMTLMV which is the monthly interest rate of UK resident banks and building societies sterling Standard Variable Rate (SVR) mortgage to households (not seasonally adjusted).  December 2012 sees this reach 4.35% which month on month is a tiny uptick of 0.01% and year on year is an increase of 0.23%.  We now need to be careful with this dataset and keep an eye on other mortgage types because the new Funding for Lending Scheme (FLS) is now starting to distort the UK mortgage market.  I’ll provide full details in a post soon however I will say that 2, 3 and 5 Year Fixed Rate Mortgages are now continuing falling.  

UK House Value

The stock market uses the Price to Earnings Ratio (P/E) as a possible valuation metric.  I choose to use the same metric to assess housing value and show this in my first chart below.  For Price I use Nominal House Prices and for Earnings I use the UK Nominal Earnings multiplied by 52 to convert to Annual Earnings.   This shows that today we are sitting on a P/E of 6.6 which down from 6.7 last month.  This means property is better value this month than last.  While being a long way off the peak value 8.3 we are also still a long way off of the 4.6 seen in January 2000.

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Unfortunately, the Average Weekly Earnings dataset limits this analysis to January 2000.  I however want to look at longer term trends to try and judge where fair value may be and even what P/E lows we could expect going forward.  To get an indicator of this I use an older similar dataset which was discontinued by the ONS in September 2010.  This was the Seasonally Adjusted Average Earnings Index (AEI) for the Main Industrial Sectors.  This dataset goes back to 1990 which is sufficient to take us back through the last UK property bust.  I then convert the Average Weekly Earnings dataset to an index and overlay both on the chart below.  This shows that today we are still nowhere near fair value.

 

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A Method to Calculate Historic Portfolio Performance

I find that in life if you want to succeed at something you must have a plan.  This plan in its most basic form will include a number of goals and a timeline detailing when you intend to meet those goals.  Once you have that plan in place you must then track progress against the plan and should you deviate you should put actions in place to get you back on track.  Personal Finance is no different.

Within the Invest Wisely portion of my strategy I have two distinct goals for my Low Charge Portfolio.  The first is to beat a Benchmark that I have set myself.  Everybody’s Benchmark will of course be different.  It could be to beat the FTSE100, the FTSE 250, the Barclays UK Government Inflation-Linked Float Adjusted Bond Index, a combination of these or something completely different.  Remember when you set your Benchmark you must ensure it has a similar risk profile to your investments and contains investments that are as close to yours as possible.  What good is it to spend time developing a Low Charge Portfolio and Strategy if you can’t at least match (for those of us where personal finance is a hobby) or beat a simple Benchmark (for those of us where personal finance is a hobby or chore).  If we can’t meet this goal then we’re probably better off just buying a Vanguard LifeStrategy Fund.

The second aim is for my portfolio to over the long term meet or exceed a Real Total Return goal that I have set myself.  This is defined as over the course of my investing career the sum of the capital gains within my portfolio and the dividends paid must exceed UK Inflation by a specific amount.  In the interests of full transparency I must point out that I am current not meeting my goal however by tracking progress I at least know why I am missing and have planned actions to recover.

Let’s look at the method I use to calculate the historic performance of my portfolio assuming I want to look at Total Return.  Calculating Real Total Return is then just a simple matter of subtracting your chosen inflation measure from the calculations for the period concerned.

Calculating Year to Date and Yearly Total Portfolio Return

To make this calculation you only need 4 things:

• Access to the XIRR function within Microsoft Excel.  This function is not typically part of the standard Excel install so if you have Excel and can’t find XIRR you may need to install what is called the Analysis Toolpak.  As every version of Excel is slightly different just type “Install Analysis Toolpak” into Excel’s Help and you should get the guidance you need for your version.
• The start date for the period you are interested in analysing and the value of your portfolio on that date.  This must be the earliest date entered into Excel.
• The end date for the period you are interested in analysing and the value of your portfolio on that date.  When running the calculation this value should be entered as a negative number.
• Any cashflows into or out of your portfolio.  Note that because I am calculating Total Return all of my dividends have been reinvested in my portfolio and so I don’t need to include any dividends within the cashflows.  Cash into the portfolio should be entered as a positive number and cash out should be entered as a negative number.

A worked example is shown in the image below.

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A couple of important points:

• The first column entry into the XIRR formula is the cashflows, the second column is the dates and the third piece of data you have to enter is a guess as to what the return might be.
• It doesn’t matter what the period you are using is, whether 1 month, 1 year or 10 years, the return will always be an annualised return.  So in the example above, which is only a 3 month period, were the year continue at the current rate of return then you’d see a return of 64.7%.  You have not achieved a 64.7% return over that 3 month period.

At this point if you only want to calculate your total return for a whole year, say 31 December 2011 to 31 December 2012, then you are done.  If however you would like to know what your return is year to date then you have a little more work to do.  I do this because I don’t want to wait a whole year to understand if I’m going off plan.  I update my financial position weekly and then update my portfolio performance on the first Saturday of every month.   To do this you now need to calculate your Personal Rate of Return (PRR) which is represented by the formula:

Let’s continue with our worked example and now calculate the Personal Rate of Return.

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Another important point:

• Note how even though we are looking at a 3 month period the PRR is not equal to the XIRR value divided by 4.

So that’s how to calculate year to date and yearly performance.  Let’s move onto calculating performance over a number of years.

Investing for Income via Higher Yielding Shares

I’d like to welcome back John Hulton.  John claims to not be a financial guru, stockbroker or financial journalist, but just an average bloke who has managed to find a way through the minefields of personal finance and develop a system that works for him and, which could be helpful for other people.  He has already retired from full time work which puts him at the end game of what this Site is about – Save Hard, Invest Wisely, Retire Early.  The fact that he did this at 55 means his Save Hard, Invest Wisely element worked for him.  So while John is not a financial expert his approach has given him what many of us are chasing.  I hope you again enjoy his thoughts.

There’s no getting away from the fact that the past 4 or 5 years have been tough for savers and pensioners.  The Bank of England has kept interest rates at a record low 0.5% for the fourth consecutive year.  Annuity rates are equally at an all time low and there appears little reason to think there will be any significant change for the foreseeable future.

According to a recent study by Prudential, people retiring this year will have a typical yearly income of £15,300, around £3,400 less than those who retired in 2008.  In a separate report by Moneyfacts, they found that annuity income fell by 11.5% in 2012, the biggest annual fall since 1998.

Understandably, many savers are looking for alternatives which can provide a better return than the 2% or so on offer from their bank or building society.  Likewise, people approaching retirement are investigating alternatives to the rock-bottom annuity rates currently on offer.

One way to maximise income is to invest in a diverse portfolio of large, well-run companies which will grow their earnings and profits for the decades ahead.  Companies which have weathered the storm over the past 5 years and have also managed to maintain a steady stream of rising dividends are likely to continue doing this in the future.

In my ebook Slow & Steady Steps from Debt to Wealth I set out a step-by-step guide to generating income from the stockmarket.  I have found, through a process of trial and error over several years that a combination of individual higher yield shares together with a portfolio of investment trusts gets the job done for me.

In a post earlier this month I outlined some of the benefits of investment trusts and in this second part, I will cover my higher-yield shares portfolio.

For me, the main advantage of holding individual shares is lower ongoing costs - after the initial purchase, which could be as low as £1.50 plus 0.5% stamp duty, there are no further costs involved in holding the portfolio.  I suppose if you are in the build phase and reinvesting dividends from time to time in more shares, there will be some further minor cost but basically, once you have purchased your 15 or 20 shares that’s it.  With investment trusts there are the same initial costs to purchase PLUS the trusts annual expenses and management fees - usually between 0.5% and 1% (plus any performance fee).

The FTSE 100 Cyclically Adjusted PE Ratio (FTSE 100 CAPE or PE10) – January 2013 Update

This is the Retirement Investing Today monthly update for the FTSE 100 Cyclically Adjusted PE (FTSE 100 CAPE).  Last month’s update can be found here.

As always before we look at the CAPE let us first look at other key FTSE 100 metrics:

• The FTSE 100 Price is currently 6,104 which is a gain of 4.0% on the 03 December 2012 Price of 5,871 and 7.1% above the 02 January 2012 Price of 5,700.
• The FTSE 100 Dividend Yield is currently 3.64% which is a little down against the 03 December 2013 yield of 3.73%.
• The FTSE 100 Price to Earnings (P/E) Ratio is currently 11.78.
• The Price and the P/E Ratio allows us to calculate the FTSE 100 As Reported Earnings (which are the last reported year’s earnings and are made up of the sum of the latest two half years earnings) as 518.  They are up 1.1% month on month but down 6.5% year on year.  The Earnings Yield is therefore 8.5%.

The first chart below provides a historic view of the Real (CPI adjusted) FTSE 100 Price and the Real FTSE 100 P/E.  Look at the trend line of the Real Price.  After you strip out the effects of inflation the perceived market value is doing not much more than oscillating above and below a flat line.  This then presents a problem for any buy and holder reinforcing the importance of dividends.  The second chart provides a historic view of the Real Earnings along with a rolling Real 10 Year Earnings Average for the FTSE 100.

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As always let us now turn our attention to the FTSE 100 Cyclically Adjusted PE.  This is also shown in the first chart above.  For completeness let me also detail the usual reminders.  I do not use P/E ratio’s to make investment decisions from and instead use this CAPE.  This is because the P/E ratio does not take the business cycle into account which the CAPE tries to adjust for.  The method used is similar to that developed by Professor Robert Shiller for the S&P500.  The calculation is the ratio of Real (ie after inflation) FTSE 100 first possible day of the month Price to the 10 Year Real (CPI adjusted) first possible day of the month Earnings.  Unfortunately the dataset I have created only goes back to July 1993.  Therefore to get a meaningful set of numbers I have had to average in to a PE10 for the first 10 years.  What this means is that July 1994 is actually a PE1, July 1995 is a PE2 and so forth until July 2003 when we have a full FTSE 100 PE10.