Investing in a high inflation environment
It was back in August of last year that I first referenced the growing inflation risk in New Zealand and labelled it the 'silent thief'. It is now official; the silent thief has arrived. Stats NZ1 have confirmed that the Consumer Price Index (CPI) increased 5.9 percent for the 12-month period ended December 2021. This is the highest rate experienced over the last 30 years and anecdotal evidence suggests that many supply chain pressures are yet to peak.
Offshore, the situation is similar with the United States CPI climbing to 7% in 2021. Like New Zealand, this is also a multi-decade high; in fact, it's the highest rate since June 1982. And perhaps more telling is that the United States central bank, the Federal Reserve, is no longer referring to inflation as 'transitory' but acknowledging the potential for it to be 'persistent'.
OK, so no big surprise here; anyone who has been supermarket shopping over the last six months is well aware of this. At current levels, inflation now feels less like a silent thief and more like daylight robbery. It is also a reminder that, within the background of what might be considered normal inflation, rapid and more disruptive spikes do occur.
The challenge is, how do we protect and grow our wealth in an environment with higher inflation?
Not all investments are created equal when it comes to their ability to grow faster than inflation. This creates an environment where there will be winners and losers and, sadly, further potential for New Zealand's wealth divide to be exacerbated. The biggest losers in a high inflation environment is anything with a fixed return or anyone on a fixed income.
This means that fixed interest investments whether they are bonds or term deposits are particularly susceptible to losing value. Although central banks do increase interest rates to try to head off inflation, on average it is never enough to make up for the falling purchasing power of the capital invested.
Historically, property has been a good hedge against inflation. This is because the underlying value of materials within a structure and the land that it sits on are effectively repriced by inflation and rents increase accordingly.
For many baby boomer Kiwis, property has been their main hedge against inflation; employing a 'buy more and borrow more' philosophy and it has worked, at least until now. It will be interesting to see if property is quite as robust in this cycle. With New Zealand property prices at intergenerational highs relative to average income, and strong political pressures to try and limit further gains, property might not be the 'safe bet' against inflation this time.
The big question is, how do company shares respond in an inflationary environment? This is critical as shares will often make up the majority of a portfolio with a longer-term focus. As a share is literally a share, or equity interest, in an individual company, it is the activities of the company that dictate how well it performs and this will ultimately be reflected in its share price.
In the first phase of an inflationary cycle, when central banks first increase interest rates, this tends to depress the value of all shares. Over time, this settles down as the underlying profitability (or otherwise) of each company will be visible and the market price of the shares will respond accordingly.
As inflation is in essence 'more money chasing fewer things', investing in 'things' makes sense. Things are made up of raw materials, or in investment terms, commodities.
Commodities are a wide-ranging asset class covering everything from milk powder to aluminium. It also includes energy commodities such as oil and gas. There are different ways to gain exposure to these assets, including by direct ownership via shares of commodity producers or via indirect exposure through an index.
Throughout history, precious metals have also been used as a hedge against inflation with gold being the classic case. But once again, how you choose to gain exposure to precious metals becomes the question.
This is the first significant inflation cycle where digital assets, such as Bitcoin, are easily available and freely traded. If they are viewed as 'digital gold', then one would expect them to help protect against inflation. However, sentiment also drives this market strongly and their value as a specific hedge against inflation is yet to be proven.
In summary, investing in a high-inflation environment becomes more complicated. Some of the so-called safe haven assets, such as fixed interest, will prove to be not so safe.
Like most things in life, there is no 'free lunch'; enduring short-term volatility is the price you will need to pay to protect the long-term purchasing power of your capital.
Offshore, the situation is similar with the United States CPI climbing to 7% in 2021. Like New Zealand, this is also a multi-decade high; in fact, it's the highest rate since June 1982. And perhaps more telling is that the United States central bank, the Federal Reserve, is no longer referring to inflation as 'transitory' but acknowledging the potential for it to be 'persistent'.
OK, so no big surprise here; anyone who has been supermarket shopping over the last six months is well aware of this. At current levels, inflation now feels less like a silent thief and more like daylight robbery. It is also a reminder that, within the background of what might be considered normal inflation, rapid and more disruptive spikes do occur.
The challenge is, how do we protect and grow our wealth in an environment with higher inflation?
Not all investments are created equal when it comes to their ability to grow faster than inflation. This creates an environment where there will be winners and losers and, sadly, further potential for New Zealand's wealth divide to be exacerbated. The biggest losers in a high inflation environment is anything with a fixed return or anyone on a fixed income.
This means that fixed interest investments whether they are bonds or term deposits are particularly susceptible to losing value. Although central banks do increase interest rates to try to head off inflation, on average it is never enough to make up for the falling purchasing power of the capital invested.
Historically, property has been a good hedge against inflation. This is because the underlying value of materials within a structure and the land that it sits on are effectively repriced by inflation and rents increase accordingly.
For many baby boomer Kiwis, property has been their main hedge against inflation; employing a 'buy more and borrow more' philosophy and it has worked, at least until now. It will be interesting to see if property is quite as robust in this cycle. With New Zealand property prices at intergenerational highs relative to average income, and strong political pressures to try and limit further gains, property might not be the 'safe bet' against inflation this time.
The big question is, how do company shares respond in an inflationary environment? This is critical as shares will often make up the majority of a portfolio with a longer-term focus. As a share is literally a share, or equity interest, in an individual company, it is the activities of the company that dictate how well it performs and this will ultimately be reflected in its share price.
In the first phase of an inflationary cycle, when central banks first increase interest rates, this tends to depress the value of all shares. Over time, this settles down as the underlying profitability (or otherwise) of each company will be visible and the market price of the shares will respond accordingly.
As inflation is in essence 'more money chasing fewer things', investing in 'things' makes sense. Things are made up of raw materials, or in investment terms, commodities.
Commodities are a wide-ranging asset class covering everything from milk powder to aluminium. It also includes energy commodities such as oil and gas. There are different ways to gain exposure to these assets, including by direct ownership via shares of commodity producers or via indirect exposure through an index.
Throughout history, precious metals have also been used as a hedge against inflation with gold being the classic case. But once again, how you choose to gain exposure to precious metals becomes the question.
This is the first significant inflation cycle where digital assets, such as Bitcoin, are easily available and freely traded. If they are viewed as 'digital gold', then one would expect them to help protect against inflation. However, sentiment also drives this market strongly and their value as a specific hedge against inflation is yet to be proven.
In summary, investing in a high-inflation environment becomes more complicated. Some of the so-called safe haven assets, such as fixed interest, will prove to be not so safe.
Like most things in life, there is no 'free lunch'; enduring short-term volatility is the price you will need to pay to protect the long-term purchasing power of your capital.
1. Annual inflation hits a three-decade high at 5.9 percent, Stats NZ/Tatauranga Aotearoa, 22 January 2022.
This document has been provided for information purposes only. The content of this document is not intended as a substitute for specific professional advice on investments, financial planning or any other matter.
While the information provided in this document is stated accurately to the best of our knowledge and belief, New Zealand Funds Management Limited, its directors, employees and related parties accept no liability or responsibility for any loss, damage, claim or expense suffered or incurred by any party as a result of reliance on the information provided and opinions expressed except as required by law.
While the information provided in this document is stated accurately to the best of our knowledge and belief, New Zealand Funds Management Limited, its directors, employees and related parties accept no liability or responsibility for any loss, damage, claim or expense suffered or incurred by any party as a result of reliance on the information provided and opinions expressed except as required by law.
***
Peter Ashworth is a Principal of New Zealand Funds Management Limited and a Financial Adviser based in Dunedin. The opinions expressed in this column are his own and not necessarily those of NZ Funds. His disclosure statements are available on request and free of charge.
***
First published in the Otago Daily Times on 14 Februrary 2022, as 'How do we protect and grow wealth during times of inflation?'
