Pulling clear of inflation

By BRENT SHEATHER

There are lots of ways of measuring how an investment performs, but for your average investor the big question is likely to be: am I beating inflation?

Faced with this priority, the typical response from the financial planning and stockbroking fraternity over the years has been to reach for their favourite investment - company shares.

Over the very long term this strategy has worked brilliantly, but many 60-year-olds don't have the 20 years or so that the experts say is necessary to guarantee success. In the short term anything can happen.

For example, Mum and Dad who took the plunge in January 2000 and bought shares in the WiNZ Fund (which invests in an index of international shares) were looking at a negative real return of about 55 per cent by the end of last month. In other words, inflation has been about 10 per cent and the shares' value is down by 45 per cent.

That's not a great start, and it gets more depressing when you realise that if international shares return 7 per cent a year from here on - an optimistic assumption - the investment will take another 14 years to catch up to inflation at 2 per cent a year.

So, share performance is too volatile to be the total solution.

But help is at hand: about this time each year, the economic research team at Barclays Capital of Britain publish their Equity Gilt Study (EGS), which analyses the annual returns from shares, Government bonds ("gilts" as the British call them) and cash in Britain and the US, since 1899 and 1925 respectively.

The 2004 edition includes a chapter entitled "Comparing Real Assets" in which the authors compare the success of shares, property, commodities and inflation index linked bonds in keeping up with inflation.

Before getting to the results, it is worth thinking about why beating inflation is such a big deal for investors, and what economists mean by "real" assets.

Most of the time, an asset's value comes from the fact that it produces cash which can then be used to buy goods and services. Over a long time, say 20 years, the cost of the things we buy generally rises. So, to keep up our standard of living, we need to ensure that the cashflows we receive from our investments increase at least as quickly.

An added attraction is that if the amount of cash an investment produces keeps up with inflation, then - all other things being equal - the price of the investment is also likely to be maintained in real terms.

Real assets, therefore, are assets whose value has traditionally risen at or around the same rate as inflation.

Owning real assets is definitely the way to go in times of inflation.

Barclays key findings are as follows:

"Using more than 100 years of historical data we examine the performance of UK equities during three distinct inflation periods: deflation during the late 1920s and early 1930s; high inflation during the 1970s; and low and stable inflation in recent years. Our analysis reveals that equities have produced negative real returns under each of these scenarios.

"Similar analysis conducted for commodities and property reveal that commodities provide the best inflation hedge during periods of unexpected sharp rises in inflation. Property posted negative real returns during the stagflationary 1970s yet managed to outperform equities by almost 30 per cent."

"Equities, property and commodities provide inflation protection over the long term. Testing the performance of the assets over different time periods reveals that in order to achieve consistent positive real returns, the investor must hold equities for at least 20 years, property for at least 15 years and commodities for just 10 years."

The obvious question is, how have New Zealand investments coped?

The news is good, although some of the data is for a shorter time than ideal.

From 1928 to 2003, New Zealand shares have positively trounced inflation. In fact, the compound return from the local sharemarket - 10 per cent a year - is almost as good as US shares, which returned 10.4 per cent a year over a similar period.

But the returns on shares are volatile. In the period in question, there are 65 10-year periods - 1928-38, 1929-39 etc - and the return on shares has beaten inflation for 88 per cent of those periods.

Based on historic data, not even holding shares for 15 years would absolutely guarantee a real return.

New Zealand bonds have also delivered a patchy performance. Taking all the 10-year periods between 1930 and 2003, bonds beat inflation in only 60 per cent of those periods.

In the inflationary 1970s, specifically the period from 1972 to 1982, inflation was much higher than the pre-tax return on Government bonds, reflecting external events and the silly economic management of the time.

Residential property has beaten inflation in every 10 and 15-year period over the 33 years for which we have data, which is certainly a good effort and maybe explains why so many Herald readers love that asset class.

But before anyone gets too excited and puts all their money into residential property, we need to remember one of the first rules of investment: past returns are not indicative of the future.

Although in the past we regularly had periods of negative real interest rates - interest rates that were lower than inflation - today's lenders aren't so silly.

Also, higher property prices mean rental yields in the future are likely to be lower than they have been in the past.

Today the rental yield on that three-bedroom house in Remuera is about 4 per cent - before costs - less than the 6 per cent you can get from New Zealand shares.

We also need to realise that the share and bond data we have covers a much larger sample than the data for residential property, and that a high proportion of the negative real return years for bonds were before 1974, when residential data begins.

To reinforce the fact that no asset - including property - provides a free lunch, consider the plight of the Japanese Mum and Dad who got into the Tokyo residential market at the top: Mr & Mrs Yamamoto who paid, say, 100 million for that one-bedroom apartment at the top of the market in March 1988 would be looking at selling it for 30 million yen today, a fall of about 67 per cent.

The prices are my guesstimates, but that is the extent of the decline in prices according to the Japanese Real Estate Institute.

So how do the £100,000-a-year (plus bonus) rocket scientists at Barclays Capital in London recommend we deal to the risk of inflation? No surprises there - the answer is a diversified portfolio with real assets including inflation-indexed bonds (great if you're investing for only five or 10 years), property, commodities, shares, and some nominal assets too, I guess, like AA-rated bonds just in case inflation is lower than expected.

* Brent Sheather is a Whakatane investment adviser