Investment

How Inflation Affects Investment Returns

What is Inflation?

In general terms, inflation is the increase in the cost of goods and services in the economy during a given period. More money is needed tomorrow to buy the same things you bought today. Inflation is often shown in percentage terms and is usually measured monthly, quarterly and yearly by the Australia Bureau of Statistics (ABS) in Australia.

How inflation affects real returns - SMSF Mate

When the economy is on the up, demand for goods and services typically outruns the supply and causes prices to rise, and this is how we get inflation. Consumer spending overtakes the creation of goods and services, the amount of money in an economy outstrips the amount needed everyday transactions, which caused the purchasing power of the currency to decline.

Average Inflation Rates from 2000 to 2020

The average inflation rate was 2.63% (see table below)

Year March June Sept Dec Annual
2020 2.20%
2019 1.30% 1.60% 1.70% 1.80% 1.60%
2018 1.90% 2.10% 1.90% 1.80% 1.90%
2017 2.10% 1.90% 1.80% 1.90% 1.90%
2016 1.30% 1% 1.30% 1.50% 1.30%
2015 1.30% 1.50% 1.50% 1.70% 1.50%
2014 2.90% 3% 2.30% 1.70% 2.50%
2013 2.50% 2.40% 2.20% 2.70% 2.50%
2012 1.60% 1.20% 2% 2.20% 1.70%
2011 3.30% 3.50% 3.40% 3% 3.30%
2010 2.90% 3.10% 2.90% 2.80% 2.90%
2009 2.40% 1.40% 1.20% 2.10% 1.70%
2008 4.30% 4.40% 5% 3.70% 4.40%
2007 2.50% 2.10% 1.80% 2.90% 2.30%
2006 2.90% 4% 4% 3.30% 3.50%
2005 2.40% 2.50% 3.10% 2.80% 2.70%
2004 2% 2.50% 2.30% 2.50% 2.30%
2003 3.30% 2.60% 2.60% 2.40% 2.70%
2002 3% 2.80% 3.20% 2.90% 3.10%
2001 6% 6.10% 2.50% 3.10% 4.30%
2000 2.80% 3.10% 6.10% 5.80% 4.50%

What Causes Inflation?

One of the most common causes of inflation is rising commodity prices. 

The price of essential goods and services will generally increase when commodity prices rise, especially the price of oil. When oil prices rise, it means that the cost of petrol will increase along with it, causing the prices of anything transported planes, trains and automobiles. Airfare prices rise, causing tickets prices to rise and so on. 

It is often said that a hike in oil prices can be seen as a tax of sorts which can dampen a country’s economic activity.

In recent history, extreme rises in the price of oil have been closely followed by economic recessions with notable examples in the 70s, 80s and early 90s.

Let’s not forget that foreign exchange rate fluctuations can also cause inflation. When a country’s currency weakens, imported goods become more expensive, which creates upward price pressure overall. 

Due to the fact that inflation eats away at investment returns over a period of time, it is common to see investors shifting their portfolio to markets with a lower rate of inflation.

How Do We Measure Inflation?

Perhaps the easiest way to think about inflation is to imagine a shopping trolley of goods and services which are purchased by Australian households. Every quarter the same shopping trolley is filled and as prices change from quarter to quarter, so does the total cost of the shopping trolley. Inflation is merely comparing the change in prices from one period to the next.

There are a few different ways you can measure inflation – headline inflation and core inflation with the latter aiming to remove the volatile components which ave been known to cause unnecessary noise in the headline inflation figure. 

The measurement of inflation that most people pay attention to is the Consumer Price Index (CPI) which tracks the prices of goods and services, like household costs, healthcare and transportation. Another important measurement of inflation is the Producer Price Index (PPI) which measures mainly consumer goods, and some capital goods. PPI is undoubtedly a leading indicator when it comes to changes in the inflation cycle. 

Investment Returns and Inflation

When it comes to managing your SMSF portfolio, it’s important to understand inflation, because of the risk it poses to your investment returns. It’s also the critical measure of which the Reserve Bank of Australia monitors for our monetary policy and the change of interest rates. 

All SMSF investors should be aiming to increase their portfolio’s value and of course, their purchasing power. If the investment returns can’t keep up with inflation, then your purchasing power in real terms is impacted.

For instance, if your portfolio returns 5% in one year before inflation, in a country where inflation is 3%, you have achieved only a 2% return in real terms (adjusted for inflation). 

Inflation is particularly damaging to an investor with exposure to fixed income or government/corporate bonds. Because the interest rate remains the same until maturity, as inflation rises, the purchasing power of the interest payments falls.

Interest rates will usually rise with inflation which means bond prices fall impacting the total return on any bond holdings in your portfolio.

Inflation is not all bad news, though, there are a few assets which rise in price when inflation increases. Equities are a prime example and can be an excellent long-term investment relative to inflation. When companies raise their prices, it could translate into better earnings. It is worth noting that in the short-term, equities can show negative performance if inflation appears unexpected in the economy. As we discussed earlier, commodities generally rise with inflation, so perhaps a BHP Billiton or Rio Tinto might be a good pick if inflation accelerates. 

How is Inflation Controlled?

There are a number of central banks around the world who watch inflation very closely. The Reserve Bank of Australia (RBA) aims to achieve an inflation rate of 2–3%, on average, over time and does so by adjusting interest rates. When the RBA lowers interest rates, it encourages lending and aims to increase the money supply in the economy. Banks lend to consumers and businesses, which creates spending and should push inflation higher.

Inflation in Australia has fallen significantly since the 70s and 80s and remained relatively stable since the RBA introduced the inflation rate target in the early 90s. 

Your SMSF Portfolio

Some SMSF investors believe that gold is a good hedge from rising inflation as it is regarded as a store of value. It has a limited supply, unlike cash which can be printed by central banks.

It could also be said that active fixed income investment managers generally perform better than passive managers as they can adjust their investment exposure to things which offer protection from inflation.

In most cases, equities have a positive correlation with inflation as businesses pass on rising costs on to customers. Generally, banks benefit from rising interest rates as it increases their profit margins.

 

General Advice Warning

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