We are in different investing times now than in the past 40 years.
For the first time in many people’s investing careers, inflation is becoming something to properly consider as an impact on portfolios. Along with this is the allied effects of rising rates, the main tool of central banks used to combat inflation.
Of course this time is different (hint: it probably isn’t). 40 years ago we weren’t exiting from a global pandemic which is rewriting global supply chains and we didn’t have a land war in Europe.
However, we did have an oil price shock and imminent recession, which reset the world for a decades-long period of financialisation and globalisation.
Long term investors might recognise the following chart:
It shows the 10-year Australian government bond yield having just broken out of a 30-year downtrend. Of course this may or may not continue…
The 10-year yield is considered the benchmark “cost of money” for many long-term investments, particularly equities, as it forms the risk-free rate used in calculating asset valuations.
Inflation is also on the rise, with the last CPI print finally getting back inside the Reserve Bank of Australia’s (RBA)’s target band of 2-3% for the first time in 6 years, with higher rates of inflation forecast given the pressures mentioned above.
So what to do?
As we have repeatedly mentioned in many articles over the last few years, Australians retain the highest risk pension portfolios in the developed world, with huge relative allocations to equities.
Inflation has a mixed effect on equity performance. As usual the best data is in the US, and the below chart shows the performance of the S&P500 in various periods of inflation:
What seems to be the case is that not when there is high inflation stocks perform badly, but when the rate of inflation is increasing do they show a negative return. We have seen this so far this year again, with the ASX200 and the S&P500 both down this calendar year as inflation has continued to accelerate.
However, we know investors will likely look through this volatility (and to be fair it is only -0.5% and -4.5% respectively) in their equity allocations, and as such are unlikely to make large changes to their overall asset allocations.
Therefore, we should concentrate on the other asset classes, namely property, bonds and cash.
The Australian Bureau of Statistics (ABS) reports strong growth in property prices over the last year or so, no doubt as a response to interest rates being lowered and held at near zero through the pandemic:
Therefore, as interest rates rise, it would be reasonable to expect these prices to revert to a longer term mean, and the rate of increase slow, if not result in price falls.
However property, being relatively illiquid and also (if bought historically) likely to provide a decent income, is also not likely to change much in terms of overall asset allocation. Plus, if you are living in your main asset, there are significant lifestyle benefits alongside asset price growth.
Cash is the real problem child in this scenario. SMSF investors stubbornly maintain a very high level of cash in their asset allocation of around 21% - down from around 26% 3 years ago, but still incredibly high - despite rates being held near zero for nearly 2 years, and basically low since the GFC (apart from the famous Westpac 8% 5-year term deposit, now a distant memory).
Inflation kills cash – it is that simple. Term deposit (TD) rates range hugely in this market. We have seen 5-year TDs from the CBA at 0.30%, up to 5-year TDs from Macquarie Bank at 1.65%.
However, with headline CPI at 3.5% and predicted to rise in the next quarterly report to 4% (if the Melbourne Institute gauge is a reliable leading indicator), the reality here is that both return simply differing levels of negative real returns.
Assuming 3% CPI, money in the CBA TD will give you a compounded real return of approximately -14% over the 5-year period. The Macquarie is better at approximately -7%, but still a very poor result.
As the most ‘cash-like’ of the main asset classes, being low risk and income producing rather than capital assets, bonds can also suffer in periods of rising or high inflation.
Commentators love to call out the end of the great bond bull market, as if they haven’t done enough spruiking of risky assets over the last few decades.
This is certainly true of longer dated fixed rate bonds such as the 10-year government bond mentioned at the beginning of this article, however this is only a very small part of the story.
Indeed, as a low-risk investment, for those (sensible) investors who would rather not expose their hard-earned wealth to the volatility and potential capital loss of the equity or property markets, then an investment grade bond portfolio will deliver capital stability and secure income, at a rate of return that comfortably exceeds inflation.
Our current Conservative Sample portfolio (here), consisting of entirely investment grade rated bonds (which have an almost perfect record of returning capital over the last 30 years) and detailed in our lead article this month, is expected to return 4.60% p.a. It has a duration (sensitivity to interest rate movements) of just 3.5, meaning if the yield of the portfolio rises by 1%, the capital value will likely fall by just 3.5%.
Also key is that this is a mark to market movement in price only – holding the bonds to maturity will result in the expected return being actualised, with no loss unless an issuer defaults.
About 62% of the portfolio is either floating rate or inflation linked, giving protection against both rising rates and inflation.
Once again, investment grade bonds – and not just the ones used to make negative headlines but solid corporate bonds of various types – can protect investors’ capital through volatile markets and when other low risk investments erode capital in real terms.
We encourage you to reach out to investigate how we can improve your post-inflation returns whilst still investing in low-risk assets.