High inflation can erode wealth, but skilful advisers can help their clients maintain and grow the value of their portfolios, Peter Dorrian writes.
Inflation came in at 2.7 per cent in the December 2013 quarter, according to the Australian Bureau of Statistics. That fell in line with the 10-year annual average of 2.73 per cent and within the Reserve Bank of Australia’s target range of 2 per cent to 3 per cent.
However, inflation is up from 2.2 per cent for the 12 months ending in September, and the Consumer Price Index rose 0.8 per cent in the fourth quarter. Fruit and vegetable prices jumped 7.6 per cent in the quarter due in part to adverse weather conditions, while the cost of education, alcohol and tobacco, housing and healthcare rose by 4 per cent.
Inflation is a threat that financial advisers shouldn’t ignore for too long, especially given the loose monetary policy being employed by central banks. The current environment, where central banks are flooding the economy with money, interest rates are at record lows and the outlook for global growth is improving, is typically a recipe for inflation.
Rising prices for goods and services mean today’s money will be worth less in the future. Basically, inflation requires that investments deliver greater nominal returns just to retain their value. The higher the inflation rate, the harder investments have to work. If prices are rising at an annualised rate of 3 per cent or 4 per cent, for example, investments must earn that amount – after tax – to simply keep up.
Fighting inflation
Investments that target returns above the rate of inflation can protect and potentially increase clients’ future purchasing power.
One investment is designed specifically to beat inflation: inflation-linked, or inflation-indexed, bonds. These bonds are designed so that principal payments are indexed to the rate of inflation, typically the CPI, and interest payments adjust to reflect the changing value of the principal, ensuring that investors receive a return above the rate of inflation over the life of the security.
In addition to inflation-linked bonds, historically, gold and other commodities that tend to rise in value as inflation increases have acted as inflation hedges, while growth assets such as global and domestic equities can also play important roles.
Over the long term, Australian equities have returned close to 10 per cent annualised, while global equities (hedged) have delivered around 5.3 per cent. Even if domestic equities deliver high single-digit returns over the next decade, they’ll still likely beat inflation by a decent margin.
Listed property has also delivered strong returns over the last 20 years. Research by the Australian Securities Exchange and Russell Investments shows listed property returned 7.1 per cent annualised, while Australian fixed interest returned 7.5 per cent and global fixed interest delivered 8.5 per cent over the same period.
Finally, with a growing number of retirees and other investors focused on income and capital preservation, clients’ interest in strategies that seek absolute real returns is increasing. These investments commonly target a return above CPI.
While inflation in Australia is currently low, it is still present, and it may well move higher. It’s a risky strategy to wait until inflation has hiked up again before repositioning portfolios.
American educator Reed Markham put it this way: “If you’re standing still, you’re also going backwards.”
Australian investors can no longer earn positive real returns by simply investing in cash. Instead, they must consider the optimal combination of portfolio risk and return in order to satisfy both their income and wealth creation goals. In order to generate this inflation beating return, additional portfolio risk must be assumed, which means that portfolio diversification will become increasingly important.
