Canny view: Are concerns about inflation inflated?

Data suggest that simply staying invested helps outpace inflation over the long term. Photo / Supplied

OPINION:

Okay, annual inflation is now running at 3.3 per cent. In the June 2021 quarter compared with the March 2021 quarter, the New Zealand Consumer Price Index (CPI) rose 1.3 per cent, a much stronger lift than market expectations.

So what does it mean to us?

From restaurant meals to second-hand cars, to homes in regional areas, to toilet paper in supermarkets, all of us can now talk more about how our money is buying less.

There are a lot of theories about what is included and not included (and why), and what makes up how much of New Zealand's CPI number, so anecdotes about random observations are interesting, but not that useful.

In the US, where there are bigger concerns, annual inflation accelerated to 5.4 per cent in June of 2021 from 5 per cent in May, hitting a fresh high since August of 2008, and well above forecasts of 4.9 per cent. Naturally it led to a small ruckus on world markets in recent weeks, especially with economists indicating inflation is set to move higher and the outcomes might persist well into 2022.

Nick Stewart.

It's understandable investors are concerned about inflation and its negative impact on the purchasing power of their invested wealth.

But one thing we all need to remember is there is no shortage of opinions about inflation's direction. We know where inflation is, but anyone claiming they know where inflation is going is guessing.

The pandemic has seen many people hunker down in their own fortress. Spending up big on durable goods around their house as their hair and beards grow, instead of taking holidays, eating out, seeing a show, movie, or getting a haircut.

When the demand for durable goods increases sharply, it results in shortages and supply constraints that drive up prices. This set of circumstances seems unlikely to last. Eventually people will be vaccinated, and their spending will transition from durables to services.

The big question: If inflation does come raging back, how does that affect your portfolio?

The last big occurrence of inflation was back in the 1970s and '80s. Anyone around then would remember double-digit spikes. The prospect of double-digit inflation seems outlandish given where we currently are, but it's still useful to get an understanding of how assets have performed.

The longest data available across various asset classes is in the US. We'll only focus on the '70s because that's when inflation broke out, while in the '80s you might say it was an embedded part of life.

Here's how the '70s looked: For stocks it was a volatile decade, note the best and worst years. On average, across the three stock categories noted, the 1970s were more volatile than either the 1960s or 1980s and stocks were brutalised across 1973/74 when inflation really broke out. Like always, an investor had to hold on because it was followed by a massive rally, particularly in small and value stocks.

Inflation will prove frustrating when holding longer-dated bonds. In 1974 and 1979 when inflation hit double digits, long-term corporate bonds were negative and long-term government bonds were also negative in 1979. The return on US Large equities, as viewed by the major indexes such as the S&P 500, was 5.86 per cent, which is not that bad. But then add in inflation at 7.36 per cent and it has gone backwards.

This is why you will often hear screaming about gold, crypto-currency, hard assets and commodities as the thing to hold if inflation takes off. The comparison will be made with an index such as the S&P 500 and how poorly it performed during the 1970s. If you want to add a little nuance into the discussion, take a look at US Small and US Value stocks, both kept an investor well ahead of inflation over the decade.

A recent paper by global fund manager Dimensional also provides some good news for investors looking to outpace inflation over the long term. And this research also contains some sobering facts for investors trying to hedge against inflation through alternatives to inflation-indexed securities.

Despite the reassuring findings presented above, emphasising growth assets that have historically outpaced inflation may not be appropriate for everyone.

If you're highly sensitive to inflation and have a low tolerance for market risk, you'll likely want some exposure to inflation-indexed securities, and with good reason: they are designed to provide inflation protection. While stocks from certain industries, REITs, commodities, and value stocks are sometimes considered "inflation-sensitive" assets, the data provide little support that they are good inflation hedges.

Ultimately, nobody has a crystal ball to answer questions like: What will next quarter's inflation reading be? How will it compare to market expectations? Is the rise in inflation temporary or long-lived?

Fortunately, we don't need a crystal ball to address inflation in our investment portfolios. The data suggest that simply staying invested helps outpace inflation over the long term.

So our only conclusion to draw from this is the same as always. Remain diversified and have a personalised investment strategy that is closely monitored by a financial adviser as market forces change. A good adviser comes alongside you, guides you with integrity, and every investment decision will be made within the bigger context of your life goals.

• Nick Stewart is a financial adviser and CEO at Stewart Group, a Hawke's Bay-based CEFEX certified financial planning and advisory firm. Stewart Group provides personal fiduciary services, wealth management, risk insurance & KiwiSaver solutions.

• This article is prepared in association with Mancell Financial Group. The information provided, or any opinions expressed in this article, are of a general nature only and should not be construed or relied on as a recommendation to invest in a financial product or class of financial products. You should seek financial advice specific to your circumstances from an Authorised Financial Adviser before making any financial decisions. A disclosure statement can be obtained free of charge by calling 0800 878 961 or visit our website, www.stewartgroup.co.nz