Understanding the impact of inflation on investments
There has been significant media rhetoric surrounding the weakness in Australian inflation, and with it, some confusion as to the impact of inflation on investments. For those in or nearing retirement, it can be important to consider inflation when reviewing one’s investment portfolio mix – particularly since inflation can erode your capital and purchasing power over time. Below, we explore inflation in more depth.
How is inflation measured?
While there are many ways to measure inflation, the Consumer Price Index (CPI) is considered one of the most commonly quoted and pre-eminent gauges. The CPI measures the periodic change in price of a “basket” of goods and services across 11 categories―all of which account for a high proportion of the general population’s spending. This could include measuring simple things like how much a cup of coffee costs, or big-ticket items like how much consumers pay for healthcare and utilities.
To track these changes, the Australian Bureau of Statistics uses two baskets.
The first is the headline basket, which shows the cost of living for the “average” person and surveys all common goods and services, including those whose prices can shift―regardless of economic conditions. The second is the core basket, which removes items (for example, fresh produce which can be impacted by unexpected environmental factors) that have the potential for considerable month-on-month volatility, thereby removing some of the short-term distortions resulting from price changes not directly linked to growth in the economy.
The price levels of goods in the basket are then tracked and weighted based on how much consumers typically spend on them. At the end of each quarter, new numbers are released that show both quarterly and year-on-year changes―figures that not only help the Reserve Bank of Australia (RBA) paint a picture of the broader economy, but also influence government policies and, as a result, the decision-making of Australian businesses and communities.
From the 1951 consumer price inflation high of 23.9 per cent to the -11.6 per cent low of 1931,1 it is clear Australia has enjoyed lengthy periods of high inflation, deflation and, more recently, low and stable inflation2 ―with inflation currently sitting at 1.3 per cent (as of the first quarter of 2019).3 The disparity between these figures demonstrates how changeable market conditions can be.
What is the effect of inflation, and how is it relevant to investors?
Inflation can play a key role in determining where the Australian economy may be heading. Too much inflation can be a concern as it may indicate the economy is over-stimulated, with high demand for goods and services driving prices up and causing strain on businesses and consumers. Too little inflation can also be a concern as it can indicate slowing growth in an economy, with businesses and consumers perhaps unwilling to make investments or spend on goods.
Each quarter, the RBA reviews inflation using its preferred core basket CPI measurement. Along with other key data points, the central bank uses this important information to decide whether it should increase or decrease the cash rate as a means of helping the country maintain inflation within its preferred target range (i.e. between two to three per cent) and achieve economic prosperity. Over the last few years, the RBA has maintained a relatively low interest rate environment to try to boost economic growth and inflation by making “cheap” money more available to consumers. In theory, when the cash rate goes down, economic activity goes up―followed by inflation.
Changes to the cash rate can have knock-on effects in the economy and, in turn, can impact one’s investment portfolio―particularly if you have investments in Australia.
As an investor currently in or considering retirement, you may have had your eye on the low interest rate environment for some time and have been aware of how it has had an impact on your portfolio. As the return on safe assets such as cash has fallen, this has driven prices higher within equity markets and the income investments sector as investors have searched for yield. This means that we are now facing a more challenging environment for investments going forward, as many income investments no longer appear to be stacking up from a risk-return perspective and as valuations in a number of equity and other asset markets appear stretched.
Why diversification is key
As previously discussed, there is a lot of action happening―not only in Australian markets, but in global markets too. In an ever-changing environment, it is important to consider the diversity of assets in your investment portfolio and ensure that you are not overly exposed to any one asset class. Dixon Advisory’s Investment Committee maintains its view that a diversified portfolio with a balance of assets tailored to your specific retirement needs and in line with your risk profile can be a sensible approach to take both in the current environment and in future, particularly as factors such as CPI figures cause asset prices to fluctuate over time. Specifically, as equity markets continue to look relatively fully valued, we continue to encourage investors to maintain suitable allocations to areas such as property, infrastructure and alternative assets to reduce overall portfolio volatility.
1Reserve Bank of Australia, Historical Series and Explanatory Notes – excel spreadsheet, https://www.rba.gov.au/inflation/measures-cpi.html, accessed June 2019
2Australian Bureau of Statistics, https://www.abs.gov.au/websitedbs/d3310114.nsf/home/abs+chief+economist+-+70+years+of+inflation+in+Australia, accessed May 2019
3Trading Economics, https://tradingeconomics.com/australia/inflation-cpi, accessed May 2019
This insight may contain general financial advice and was prepared without taking into account your objectives, financial situation or needs. Before acting on any advice, you should consider whether the advice is appropriate to you. Seeking professional personal advice is always highly recommended. Any forward-looking statements are based on current expectations at the time of writing. No assurance can be given that such expectations will prove to be correct.