INTEREST RATES HAVE BEEN FALLING SINCE THE LATE 1970s.

Whilst the market and the media are giving us daily anxiety attacks about the valuation of our portfolio, something much more sneaky is taking place. That something is slowly eroding the value of our savings and investments and is by far and away the most destructive force against our money because it is real and quantifiable: INFLATION.

If you look at interest rates and inflationary figures for almost any developed nation, you would see that, until recently, both interest rates and inflation have been falling since the late 1970s. There were intermittent spikes in the 80s and 90s but the general trend has been downward. The chart below shows the trend for the UK (almost any developed market economy shows roughly the same trend).  

 

It becomes more interesting when you look at the chart below which was produced by Bank of America Merrill Lynch's Michael Hartnett and his team to show how low interest rates are relative to other periods in history. 

Here are some facts to show the central rate of interest during specific historical periods and to reinforce the fact that we are in unprecedented and abnormal times as far as low interest rates are concerned: 

• Mesopotamia, c 3000 BC: 20%
• Babylon, Code of Hammurabi, 1772 BC: codified earlier Sumerian custom of 20%.
• Persian conquest (King Cyrus takes Babylon), 539 BC: rates of 40+%.
• Greece, Temple at Delos, c. 500 BC: 10%
• Rome, Twelve Tables, 443 BC: 8.33%
• Athens/Rome: circa the first two Punic Wars, 300-200 BC: 8%
• Rome: 1 AD: 4%
• Rome, under Diocletian, 300 AD: 15% (estimated)
• Byzantine Empire, under Constantine, 325 AD: limit 12.5%
• Byzantine Empire, Code of Justinian, 528 AD: limit 8%
• Italian cities, c. 1150: 20%
• Venice, 1430s: 20%
• Venice, (Leonardo da Vinci paints "The Last Supper in Milan), 1490s: 6.25%
• Holland, beginning of the Eighty Years' War, 1570s: 8.13%
• England, 1700s: 9.92%
• US, West Florida annexed by the US, 1810s: 7.64%
• US, circa World War II, 1940s: 1.85%
• US, Reagan administration, 1980s: 15.84%
• US, Fed does not hike rates in September, 2015: 0-0.25%

My point here is that interest rates are in a direct relationship with inflation and until recently that trend has been downwards...for the last 30 years. But, recent data suggests that this trend is shifting and that wages are rising, commodity prices are starting to rise again  and that this is going to feed into consumer price inflation. In fact, it has already started, essentially in the USA, and as the old adage goes: 'When America sneezes the rest of the world catches a cold'.  

HOW DOES INFLATION AFFECT MY MONEY? 

Just imagine you want to buy something for:                                    €1000.
If the inflation is 3% (L.T. average), then next year it will cost:         €1030
The year after that it will cost:                                                           €1060.90
The year after that:                                                                           €1092.73

Now, compare that with the interest you might earn in the bank:     €1000
Interest at 1% (current average)                                                       €1010
Year 2                                                                                               €1020
Year 3                                                                                               €1030.30

In this simple example you would lose 5.71% of your purchasing power in just 3 years at a rate of 3%. Putting it another way, if you have €50,000 in the bank, after 3 years (using the same figures), it would be the equivalent of having only €47,145. Inflation is just the long term decline in purchasing power of your money. Bear in mind that governments around the world 'really' want inflation...really want it! It is a great way to inflate away debts and what does the world have an excess of? You guessed it...DEBT. Wage price inflation and consumer price inflation can erode those debts away so that they become less burdensome on the state. But it also erodes the true purchasing value of your savings. 

Of course, inflation is more pronounced for certain age-groups of people, depending on the services you require. The younger generation find that their cost of living has decreased in recent years due to the fall in the cost of consumer goods such as telephones. However, the older generation have found, and will continue to find, that their cost of living increases due to the rise in healthcare costs and costs of higher education for children. Have a look at the frightening chart below (it's US data but pretty much the same in all developed markets): 

WHAT IS THE SOLUTION? 
 

I imagine you know the answer by now. Investing!  It's the only fool proof way of protecting yourself against this effect and that means accepting the daily volatility that the market and the media throw your way. But thankfully, we do have some positives. We know that investing in financial markets has outperformed inflation over the medium to long term and that it provides us with a real return on our money to maintain our current standard of living. But, in any one year we may have to accept Mr Market and Mr Media are giving us a rock bottom price to purchase our portfolio.     

Always remember that inflation is a permanent and on-going NEGATIVE effect on your money. Thankfully financial markets are not, and should values fall, then that fall is only a notional value. If you remember the first rule of investing: PATIENCE, hen time will work to your advantage. Mr Market's mood will change and it is only a matter of time before he returns with a valuation which looks more appealing. 

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From the 23rd to 27th January, I will be attending our Annual Conference again and it is a great chance for me to meet a number of investment managers. We sit through a number of presentations on a range of investment led issues and inevitably there are subjects which arise which I will be able to report back to you. In the meantime, the markets look as though they have stabilised again, so we can breathe a sigh of relief, for now.