KEY POINTS:
Never mind the cost of cheese and petrol. Inflation stalks investments and strikes at the heart - their capital value.
Stagflation, which we're now experiencing, many experts say, is even worse. It's a combination of inflation with economic stagnation. So prices are going up, but company profits and
wages and salaries aren't.
We've all grown complacent about inflation thanks to the fact that we've had more than a decade in a benign environment. Investors who fail to take note could see their long-term wealth dented significantly.
CFA Society spokesman Anthony Sowerby says in general that cash and bonds tend to do worse in real terms when inflation hits and "real assets" such as property and commodities do better. Equities sit somewhere in the middle with some faring better than others.
But rules are there to be broken and nothing, even inflation, exists in isolation.
"It is not nearly as simple as one would imagine," says Sowerby. "Real assets may tend to do better than financial assets, but you need to be mindful of the current pricing."
Housing is said to be a good hedge against inflation, says Infometrics economist Gareth Kiernan, author of the annual PMI residential property overview. In inflationary times property prices rise faster as a rule, holding their real value, says Kiernan.
If, however, real estate is overvalued to start with, then it will lose some of its hedging advantage, says Sowerby. That applies to both residential and commercial property as well as real estate investment trusts (REITs), which are popular overseas.
Inflation can be seen as a property investor's friend in the long run thanks to rises in capital values. In the short term, high inflation often means higher mortgage interest rates, which leads to increased monthly payments. After the first couple of years, however, which can be painful, your payments drop in real terms as a result of inflation. The mortgage payments, especially if they're fixed, become a smaller proportion of your monthly wage packet.
The equation of property as a hedge requires that rents rise and wages and salaries increase to cover higher mortgage interest rates. If, however, investors are negatively geared and rents and wages don't rise or lag, but other costs do, they could be in big trouble. Whether interest rates will rise or inflation has been priced in is a moot point.
The Reserve Bank has indicated it expects to drop interest rates later this year, says Sargon Elias, New Zealand manager of CMC Markets. If it does, money invested from low-interest markets such as Japan and the United States flows out of New Zealand-based investments and our currency would drop - leading to increased prices of oil and other imports. If interest rates go up, money flows in and the currency tracks higher. Another group that benefits from inflation is people with consumer debt such as car loans or hire purchase (credit) contracts. Inflation makes the outstanding debt easier to pay off.
Another good general hedge against inflation is commodities and related stocks, says Sowerby. That may include direct investment in energy and other commodities, metals, mining and possibly even forestry. Companies that service these industries will also be partially sheltered from inflation.
Food-producing companies can also benefit. Even in inflationary times we still need to eat. But once again, says Sowerby, it's important to consider if these "real assets" are overvalued in the first place. Some, such as gold, may be in a price bubble.
Inflation isn't new. The good news is that today's inflation rates are not comparable to the double-digit extremes of the 1970s and 1980s. History gives an insight into the sectors that will fare well, such as commodities stocks, and those that will do badly.
In an inflationary environment some companies can raise prices. But others, such as technology companies or those selling luxury goods to a shrinking market, can't - especially if they're competing in a global market. In the short term, inflation can steal from equity investors by squeezing the profit margins of the companies they invest in. The answer to that is to gravitate towards the industries that benefit from inflation.
Shares that do poorly when inflation rises tend to be banks and other financial services companies, the real estate industry and technology companies. In the case of technology, consumers expect technology prices to fall, not rise.
Economic factors aren't the only driver in share prices and investors need to beware of the human behaviour that can create bubbles. In the late 1990s, for example, industrial stocks didn't do as well relatively as technology stocks because they were seen as old and stodgy, not new and innovative, even though the bottom line didn't justify the stratospheric prices of the latter.
Inflation is the arch enemy of fixed-rate investments. It's like borer. It eats away at the foundations until there's nothing left.
As a result, fixed-interest investments lose their sheen thanks to the hidden risk of inflation that is eating away at the capital. That's the same for any fixed-interest bank investments, debentures, or bonds (debt securities).
Those bitten hardest include conservative investors who may be living off the returns from fixed-interest investments. By spending the interest, you're eating your seed corn, says financial planner Murray Weatherston of Financial Focus New Zealand. It's like putting money under the mattress. After 10 years, that $100 buys less than it did when it was put there.
As inflation creeps up, investors need to change their basic thinking. NZX's products group manager, Geoff Brown, says in a low-inflation environment investors tend to focus on the coupon being paid by their bonds (debt securities) rather than the capital value, which falls in real terms as inflation rises.
If inflation was to remain at the higher level, investors would need the coupon to rise at a corresponding level. Most, however, tend to buy and hold their bonds.
Leaving too great a proportion of a portfolio in fixed-interest products could be disastrous, especially for retired people who need to live off the interest. If their capital is being eaten up at 5 per cent a year by inflation, it won't be around for long.
In times of inflation, inflation-indexed products make sense. Typically compensation is paid to ensure that the capital value continues to rise, but this is offset by lower interest rates or higher charges of some sort. Such investments are rare in New Zealand, although there's nothing to stop investors buying foreign-indexed investments.
The Government issued inflation-indexed bonds until 1999, maturing in 2016, and they can still be bought on the secondary NZDX market through stockbrokers.
These bonds come with a downside, says Weatherston. You have to pay tax on the inflation compensation. In terms of the bigger picture, as inflation climbs, investors need to ensure their portfolios are adjusted accordingly, Weatherston says.
