Inflation is the term used to describe the general rise in prices of goods and services over time. It also means that the purchasing power of money decreases. For example, according to the Reserve Bank of New Zealand’s (RBNZ) inflation calculator, $1.00 in the first quarter of 2000 had the same value as $1.85 in June 2024. That means inflation eroded 46% of the value of a dollar over 24 years, at an average rate of 2.6% per year.
But inflation can also vary a lot over time. This year, inflation spiked to 4.6% per year, the highest level in decades. Between March 2020 and June 2024, prices increased by 20.9%, meaning what you could buy for $1 declined by 17.3% over this period.
What is the impact of inflation on cash investments?
Inflation negatively impacts cash investments, such as money under your mattress or in a bank account that pays no interest.
To maintain and ideally increase the value of your investments and their purchasing power, you need to invest in assets beyond just holding cash. For example, bonds (and bank term deposits) are the type of investment where you lend money in return for a stream of regular interest payments, and the return of the principal invested when the bond matures. The interest income generated should cover the impact of inflation and compensate you for the risk the borrower doesn’t pay the interest or principal when it is due.
Naturally, if you spend all the interest income you receive, then over time your investment’s purchasing power will decline. This is more relevant for long-term investors such as charities that need to retain, and preferably grow, the value of their investment capital after adjusting for inflation.
Interest rates and bonds
Interest rates are influenced by inflation. When inflation rises, the RBNZ typically raises the official cash rate (OCR) to lower demand in the economy in an attempt to bring inflation down. On the contrary, when they lower the OCR, it is to stimulate demand in the economy.
When interest rates rise, the price of bonds fall, and when interest rates fall, bond prices rise.
For example, if you invested in a five-year bond in September 2020 when interest rates were extremely low, selling it now would result in a loss due to higher inflation and interest rates. Additionally, the inflation-adjusted value of your principal at maturity would have declined, meaning you weren’t properly compensated for inflation during the life of the bond.
However, if you acquired a five-year bond in September 2023 when interest rates were high, the subsequent fall in interest rates and inflation expectations would result in a profit if you sold that bond today, and you are likely to have made a gain after adjusting for inflation over the time until the bond matures, and the principal is repaid.
The role of inflation on equities and other assets
Inflation’s impact on equities is more nuanced.
Generally, equities perform well in an environment with low interest rates, low steady inflation, and good revenue and profit growth rates. However, these conditions don’t always align. Higher inflation will eventually result in higher interest rates and may see consumers spend less, and banks toughen up on lending.
Higher inflation can hurt company earnings in several ways: it can increase costs, reduce demand and lower valuation multiples. Therefore, investors should look for companies that can maintain their competitive edge and pass on higher costs to customers without losing market share. These include utilities, major technology firms, companies with well-known brands, businesses in expanding markets, and those where demand exceeds supply, and they can manage their costs effectively.
Comparing inflation hedges - gold versus equities
Many investors turn to gold as a hedge against inflation, but its effectiveness varies. Gold is more of a safeguard against economic shocks or currency devaluation, especially when a country prints more money without increasing production. The recent rise in gold prices has been driven by various factors, with central banks buying more gold to diversify their reserves away from US dollar-based investments. However, gold has provided only a slightly positive inflation adjusted return per annum over the long run.
According to economist Professor Jeremy Siegel, equities have historically delivered the highest inflation-adjusted returns. His research shows equities have consistently outperformed bonds and gold in real terms, delivering higher returns and preserving purchasing power.
In saying that, all the above outperformed the value of holding a US$1 coin, which had a negative inflation adjusted return and saw its purchasing power fall materially.
Final thoughts
While cash may seem like a safe investment in the short term, over the long term it can be risky as inflation erodes its purchasing power. Holding cash can expose you to the risk of losing your purchasing power and missing out on the opportunities that the market offers.
That is why, if your risk comfort level allows, it is essential to invest in and hold growth assets like equities and property, which generally increase in value over the long term. These assets can help you preserve and enhance your wealth, as well as provide you with income streams that can grow with inflation.
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