Inflation is an important factor to consider when it comes to managing your finances. High or rising inflation can make saving difficult as it erodes the real value of your savings and investments.
For example, if you earn 4% interest from your bank and the inflation rate is 7% the real rate of return on your money is -3%. That’s before factoring in taxes you might need to pay on the interest earned. This means that after-tax you’re likely to have even less.
You could potentially be going backwards by leaving the majority of your savings in cash and term deposits, as the price of goods and services are rising faster than the prevailing interest rates. With rising inflation, it’s a good time to be exploring other options to make sure you stay ahead.
In this article we focus on:
- What is inflation?
- What does inflation mean for investors?
- How does inflation affect businesses and consumers?
- How do you profit and protect from inflation?
What is inflation?
Inflation refers to the rise in the prices of goods and services. For example, petrol prices have increased by 5.9% per year since the 1970s.
Inflation is commonly measured by consumer price inflation (CPI), which measures the change in price of a typical basket of consumer goods and services such as housing, food, transport, and health.
The Reserve Bank of Australia (RBA) has an inflation goal of between 2% and 3% on average over time. It controls this by adjusting the interest rate in the economy. Between 2011 and 2020, interest rates have been falling while inflation has been low. This has changed since 2020 because central bank and government stimulus has driven inflation to a multi-decade high of 7.8%. Inflation is even higher in other parts of the world, like the U.K. where annual inflation has reached a 40 year high of 10.5%.
To curb inflation, central banks are expected to raise interest rates which can provide more income for savers to the disadvantage mortgage holders who may experience larger mortgage repayments.
What does inflation mean for investors?
Inflation impact on the share market
Investing in shares over a long period has been proven to be one of the best ways to beat inflation. One of the central characteristics that helps companies and their investors endure or even profit from inflation is pricing power.
Pricing power is key to a company’s ability to pass on rising input costs. It is best exerted by companies with a brand name or dominant market position (e.g. Apple). Companies with pricing power can pass rising wage or commodity costs onto customers. Warren Buffett has been quoted as saying that shares are the best possible inflation hedge because companies should be able to produce something that is able to retain its profitability in inflationary times by raising prices.
Shares have historically outperformed cash because of the ability of businesses to pass price increases along to their consumers, resulting in higher income and returns for both the company and its investors. Over the last 10 years to December 2021, Australian shares have returned 9% p.a. while global shares translated into Australian dollars have returned 14% p.a. which is well ahead of average inflation at 2.6% p.a.Source: Data as of 31 December 2022 showing 10 year returns. S&P/ASX All Ordinaries Index, MSCI World ex Australia Index, LBMA Gold Price AUD, Bloomberg AusBond Composite 0+ Year Index, Bloomberg AusBond Bank Bill Index, Australia CPI.
In contrast, keeping money in cash provided returns close to or less than inflation. This means that you will be able to buy less goods and services next year as a result of leaving your money in the bank.
Inflation impact on bonds
Inflation typically has a negative impact on bonds as the rise in prices can eat into the future interest you receive from bonds (known as coupon payments). When inflation rises, it is normally followed by a period of rising interest rates, which causes bond prices to fall (given their inverse relationship).
Some bonds can help protect against inflation such inflation linked bonds (which Stockspot offers as a theme), as the principal and interest payment is linked to changes in CPI. Stockspot recognised the risk inflation posted on government bonds and a portfolio risk mitigator and reduced our allocation to bonds in favour of gold in February 2021.
Inflation impact on housing prices
The impact of inflationary pressures on property depends on the type of inflation. When growth is slow and inflation is high (known as stagflation) like in the 1970s, property generally doesnt perform as well. Inflation generally leads to higher interest rates which in turn reduces the appeal of assets like property. This is because future cashflows including rents are worth less in today’s terms because of the erosion caused by inflation. Higher interest rates also lead to higher mortgage repayments and a reduced capacity to leverage and service the debt attached to an asset like property.
If inflation remains high and interest rates remain low (like we are seeing in the 2020s), then homeowners with a mortgage can benefit from inflation devaluaing the interest payments while the value of the home keeps up with inflation, thus lowering the overall loan to value of mortgage debt.
Inflation impact on gold
Gold has been a proven asset class over time that preserves its value and acts as a hedge against inflation. When inflation rises, the value of paper money declines (also known as currency debasement) and commodities such as gold help protect against this because they have limited supply. Gold has historically performed best when there are negative real interest rates which are when inflation is higher than prevailing interest rates.Commodities refer to a basket of oil, gas, copper, aluminum, nicket, gold and silver.
How does inflation affect consumers and businesses?
When prices rise, businesses experience an increase in input costs (referred to as cost-push inflation) such as raw materials or wages as workers seek wage increases to combat inflation. These cost pressures mean that businesses may either have to pass on these costs to the end consumer if they have strong pricing powers, or have to absorb the rise as part of their own costs, which could affect business profitability and impact their decision on spending and investment decisions.
If the price of goods and services are rising faster than wages, then the consumer’s purchasing power (i.e. the value of their dollars) is reduced. To curb inflation, the RBA may raise interest rates which can provide more income for savers to the disadvantage of variable rate mortgage holders who may experience larger mortgage repayments.
How do you profit and protect from inflation?
The best tip on how to profit from inflation is to harness the power of diversification.
By investing some of your savings in a portfolio of shares, bonds and gold, you’re able to gain exposure to investments that have historically stayed ahead of inflation. Meanwhile, diversification across sectors and geographies can help reduce the risk of being overly exposed to individual companies.
Stockspot has made the diversification part easy by offering portfolios that provide exposure to thousands of stocks and bonds around the world in a cost-effective manner. This helps to reduce the amount of risk our clients need to take to achieve returns that aim to beat inflation over the long run.