"You've never had it so good" is a phrase much repeated since Macmillan first used it as a campaign ...
"You've never had it so good" is a phrase much repeated since Macmillan first used it as a campaign theme in 1959 to remind the nation of the economic well-being of the country. Could an opportunistic politician be muttering it again in the next few months as we approach a much-touted May election?
With base rates on hold for the successive eleventh month following January's MPC meeting, there are certainly a lot of statistics pointing to a stable, healthy economy. If one uses the Bank of England base rate as a measure of economic stability and well-being, there is certainly some persuasive evidence. Rates were reduced to 7% in November 1992 and have remained below 8% since.
This eight-year period is the longest rates have been below 8% since November 1967.
And not only low but also stable. Rates have remained unchanged for 11 months, an event only repeated three times since 1965. Could this low level and stability of interest rates mean the UK has finally got to grips with inflation? The debate has certainly moved to a point where, since the mid-1990s, the actual level of inflation is discussed in tenths of a percentage point. Is inflation next month going to be 2.4% or 2.3%? Some change from the early 1990s when the debate was in the 5% to 10% range. Of course, real rates during this period were not subject to the same level of volatility, remaining relatively stable at around 4%.
So, all's well in the financial world? Certainly mortgage borrowers have enjoyed a sustained period of relatively low mortgage rates. However, lower inflation, and consequently lower interest rates, also mean lower returns for savers and investors. Clearly a distinction needs to be made between real and nominal returns, and it remains a truism that real returns do not vary quite as much as nominal returns.
Of course, investment return is inextricably linked to risk and, while interest rates over the last year have edged down and then stabilised, equity markets have become more volatile. Various explanations have been offered to explain this trend the emergence of hedge funds, matched bargain trading, program trading and so on but whatever the reason, there is no disputing the fact of volatility.
This increased volatility has implications for investors' returns, particularly those looking to invest in capital protected products. Product manufacturers construct these products using derivatives to provide the capital protection. The cost of these derivatives is based on a number of factors, of which volatility is among the most important. As volatility has increased, so too has the cost of the capital protection, thereby reducing the final overall returns that can be paid. And, as with the deposit market, lower inflation also means lower nominal equity market returns.
However while capital protected products for the cautious investor may be more expensive, increasing volatility does offer the potential for higher returns for those investors prepared to take on some of this market volatility risk. A number of products have recently emerged where the investor receives a return provided an index, usually FTSE, ends a period at or above its level at the start of that period.
Investors buying these products are effectively selling the index volatility, and as volatility has increased so too has the premium received for selling this volatility. Such products are fine as long as investors are fully aware of the risks involved. In these cases the length of the contract is crucial, as markets are generally more volatile in the short rather than the long term.
As with any new type of product it is extremely important the investor fully understands the nature of the contract they are buying. Clearly IFAs have a vital role to play where these products are concerned, explaining the nature of the product and offering advice as to the balance between the rewards on offer and the risks undertaken.
Whatever their risk profile, investors must adjust expectations in the low inflation, low interest rate environment in which the UK economy now finds itself. Specifically, they should remind themselves that it is real, rather than nominal returns they should watch out for.
David Rough is group director, Investments, at Legal and General
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