Five ways for investors to beat inflation
Inflation has been a hot topic since the start of the year. It's because we have all been saving our money during the pandemic, and as the danger recedes, we want to spend it.
However, manufacturers and many commentators thought the unemployment rate would stay higher for longer, so they got caught out as they weren't expecting consumer demand recovery to arrive so early and strong. The result was a run down in stock, meaning there is less product to meet demand across a wide range of goods - that equals inflation.
It's also been boosted by governments around the world spending up big to keep economies active during COVID-19 induced lockdowns. That stimulus will increasingly be wound back as the vaccinations globally reduce the impacts of the pandemic, but governments want to keep a lot of money in the system to ensure there is no post-pandemic slump.
Currently manufacturers are going through a process of replenishing goods throughout the supply chain, and it's not just locally, It's globally. This has put upward pressure on both the raw materials used in producing goods and the final product.
While oil, gas and coal price spikes are now dominating international headlines as countries and regions like the United Kingdom, European Union and China face shortages, it was the surge in iron ore prices that captured attention in Australia. The price of the steel-making commodity rose rapidly last year and peaked at $US233 a tonne earlier this year as China spent up on infrastructure and housing to counter the economic impacts of the pandemic.
Since June it has wound back those initiatives and put in place policies to actively reduce housing construction. The result was a rapid fall in iron ore prices to $US90 a tonne, although it has since recovered to about $US110 a tonne.
Not everyone follows the fortunes of the iron ore price, even if every $US10 fall in the metals price reduces by $A1.3 the amount of tax money the Federal Government has to spend on delivering services. However, inflation has something for everyone.
Higher rents caused by a housing shortage is an attention getter. Another for younger generations is the semi-conductor shortage caused by the inability of manufacturers to scale up and down to meet challenges from the pandemic. The result is long lead times for everything from gaming consoles to laptops, smartphones and cars.
Rising inflation is particularly an issue when wages aren't rising and interest rates are expected to go higher. Wage's growth has been anemic since the global financial crisis (GFC) of 2008-09, and interest rates are tipped to start rising in the United States next year, although not here until late 2023 or early 2024.
It's been a considerable period since inflation was an issue. In 1990 it was running at 7.48%, but it has averaged 2.4% between 1990 and 2021.
We still don't expect inflation to become a major issue as the economy normailises, and we expect it to meet the Reserve Bank of Australia's target range of 2-3% by mid-2023.
However, sector impacts could vary considerably and suffer sharp spikes in key products, like oil. It will continue to be an issue for markets, and therefore investors.
There are several steps that investors can take to help preserve their purchasing power during periods of rising inflation.
Cash is not king
With official interest rates near zero, term deposit rates have been unattractive for some time, and after inflation may be negative. Investors getting returns less than the inflation rate and tax face earning a negative real yield.
Investors should consider diversifying into assets that do better during periods of rising inflation:
Cyclical sectors typically perform better during periods of rising inflation. This includes sectors such as materials and financial companies.
For the former think of companies that manufacture products for construction and physical expansion as demand expands for thinks like bricks, concrete and steel.
Financial stocks like cash-rich American banks can do well as central banks continue to suppress bank funding costs while the pricing of long-term loans is moving higher, which is typical during an economic rebound and a dynamic that helps improve banks margins.
Manufacturers continue to replenish inventories creating demand for raw materials from lumber to oil and metals. In oil there has been under investment, limiting supply.
This supply shock is becoming more evident as the global economy reopens and demand increases.
This is leading to higher energy prices in several parts of the world. Precious metals such as gold and silver can also perform well should inflation rise and interest rates remain low.
3. Real estate
Real estate is both a hard asset and a scarce one. This allows real estate to do well, especially during periods of low interest rates which push up demand.
Investor loans for property in May increased 13.3%, according to ABS data. Average rental yields nationally were sitting at 3.41% in the June quarter, according to CoreLogic.
That was down from 3.55% in the March quarter and 3.72% a year earlier, however, rents are on the rise.
4. Inflation-linked or floating bonds
Treasury Inflation-Protected Security (TIPS) are backed by the US government making them low risk from a credit perspective. These unique types of bonds have interest rates that are linked to inflation.
Meaning their interest payments rise as inflation rises and decline during periods of deflation.
Investors who want a slightly higher return could also consider floating rate corporate bonds, these bonds offer an interest payment linked to short term interest rates, which means that the interest paid on these bonds increase as interest rates increase.
This one is probably the most important point. While inflation headlines may be scary it is important to note that there are a lot of arguments for why inflation may be temporary.
There are several reasons why inflation hasn't been persistent in the recent past, including advancements in technology that allow manufactures to increase supply once pandemic-related constraints lift, and an ageing population creating falling productivity and spending power as more people leave the workforce.
Governments have also increased debt levels to bring forward future spending to revitalise economies. This means that inflation could be a short-term phenomenon, even if it is an issue that remains in news headlines. Investors should continue to hold a variety of assets so that their portfolios can continue to perform across the economic cycle.
This information is not advice and has been prepared without taking account of the objectives, situations or needs of any particular individuals. Any individual should consider if the information is appropriate for your own situation. Individuals are advised to obtain independent legal, financial, foreign exchange and taxation advice prior to making financial decisions. Citigroup Pty Limited ABN 88 004 325 080, AFSL and Australian credit licence 238098.
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