Inflation can be good for investors

NOBODY likes the idea of inflation. It is a threat to savers and investors alike - unless they learn to make it work in their favour.

Recent official measures of inflation appeared to ease off earlier this month, with the annual rate of change in the Consumer Price Index (CPI) dropping to 2.8 per cent, back within the target range set by the Bank of England.

The Retail Price Index (RPI), which determines annual increases in state pensions and other benefits, is still rising at a relatively high rate of 4.5 per cent. While the RPI has dropped from its level of 4.8 per cent last month, which was the highest it has been since 1991, even at its reduced level, it will only take 16 years for the value of money to halve.

While many economics experts believe interest rates are likely to rise still further this year, there is an argument for looking at fixed-rate savings.

Tough competition in the savings market and the recent base rate rise to 5.5 per cent mean savers now have an opportunity to lock into some good real returns.

According to independent financial website MoneyFacts, current inflation-beating best buys include Halifax's Websaver, a fixed-rate, one-year bond paying 6.3 per cent. For a two-year option, Leeds Building Society is offering 6.2 per cent.

At these rates, savers would need to see inflation rise to more than 5 per cent before they lose out.

The threat of rising inflation has meant base rate rises, even though many pundits predict inflation will start to fall by the end of the year.

At the moment, the difference between nominal or headline rates of return and the rate of inflation - known as the real return - is rising.

For example, the gap between best-buy savings rates of over 6 per cent and the rate of inflation at 4.5 per cent is now more than 1.5 per cent. This will increase further if inflation falls. So, by opting for fixed-rate savings now, it is possible to get an increasing real return.

Linking savings to the rise in prices is another way for savers to gain from inflation. National Savings & Investments' inflation-beating Index-Linked Savings Certificates are the safest way to do so, because these are not only guaranteed by the government and are tax-free but currently pay 1.35 percentage points above inflation as measured by RPI.

Investing in equities is another route that could lead to releasing an income increasing above the level of inflation.

For long-term investors in shares, it is more important what happens to the dividend paid by individual companies rather than what happens to the share price.

As companies like to give above-inflation increases, it is the dividend growth that gives investors the "real" returns, with the added bonus of any increase in the share price. However, for this strategy to work, it is important that the dividend income is reinvested.

Some companies have announced significant increases of 25 per cent or even 50 per cent.

Any investor worried that a company that pays out too much cash to shareholders is not investing in its future can take comfort from research from Dresdner Kleinwort that shows that, over the past 12 years in the developed world, high dividend yielding companies out-performed in two out of every three years.

Mitchell Fraser-Jones, of Invesco Perpetual, whose High Income Fund is a top performer in its sector, agrees: "Quality companies grow their dividends by more than inflation and we look for those with consistent long-term dividend growth.

"Both Tesco and Capita, for example, have had double-digit dividend growth for the past ten years.

"We also select companies with strong cash flows so they can afford to fund their dividends and to invest in their business or even buy back shares, which in turn will boost their value."

Last year, dividend income rose in excess of inflation - by 9.7 per cent. However, most income funds only have yields of 3 or 4 per cent. Part of the problem is that dividend income is paid net of basic rate tax - even if the shares are held within an ISA or pension.

However, investors need to look beyond comparing a 4 per cent yield with the 6 per cent they can earn in a savings account. The yield may not look particularly attractive today. However, it is likely to rise, and investors need to look at what they will be getting in five or ten years' time. It could double in that time as the yield is likely to improve the longer investors hold the fund.

A major cause for rising interest rates and inflation around the world are higher commodity prices - that includes the price of oil, metals and even wheat and corn. For as long as demand rises faster than supply, prices are likely to rise.

There are a number of funds available that invest in either a spread of different commodities or concentrate on single commodities.

Schroders Agricultural Fund invests in "soft commodities" such as corn, wheat, sugar, coffee and cotton. Currently there are few soft commodity funds, with most investing in hard commodities such as gold. However, you don't have to buy a commodity fund to get exposure, as many fund managers will purchase some commodities - for example oil - when they feel they are appropriate, particularly those investing in China or south-east Asia.

GROWTH AND INCOME SECTOR CAN PRODUCE RISING DIVIDENDS

INVESTING in the UK growth and income sector has produced a rich history of companies paying out rising dividends, according to the Association of Investment Companies (AIC), writes Alistair McArthur.

Research shows that some 47 per cent of AIC member investment companies in that sector with ten-year histories have been able to increase their dividends in at least each of the past ten years.

It has been a similar situation in UK growth sector.

And in the global growth sector, Foreign & Colonial Investment Trust, managed by F&C Asset Management, posted the strongest dividend growth in the sector, increasing by 128 per cent over the past ten years.

This is 42 per cent higher than its nearest competitor.

Jeremy Tigue, manager of the investment trust, said: "Most of the growth, over the past five years at least, has come from the emerging markets such as India and China.

"We are confident this will continue and have already forecast further growth in the dividend of 10.4 per cent for 2007."

Tigue added that shareholders like to see annual growth in their dividend and dividend reinvestment is particularly important for those investing for the long term, not least Child Trust Fund investors who stand to benefit from their 18-year time horizon. Jemma Jackson, PR manager at the AIC, said: "It's interesting to see that so many global and UK investment companies have such a strong record when it comes to raising their dividends, while many others have at least maintained them."