The likely return of inflation and what it means for your investments

Author: Don Stammer, Stanford Brown Financial Advisers

Very few investors today have hands-on experience of how inflation affects investment decisions and returns.

The main reason, of course, is Australian inflation has been low and fairly steady since the early 1990, and the last two cyclical bumps in inflation (after the introduction of the GST in 2000 and in the mining boom of 2006-07) were mild and short-lived. Also, the global recession brought on by COVID-19 further dampened price increases and inflation expectations, here and globally.

But what will happen to inflation — here and overseas — as the massive easing in fiscal and monetary policies take effect?

The majority view among investors and commentators is inflation will remain tamed, even near-negligible.

For example, the pricing of 10-year bonds in the US and Australia suggests inflation will average rates of 1.6 and 1.2 per cent, respectively, a year over the coming decade.

In my thinking, inflation will more likely stage a reappearance over the next two or three years, rising to about 4 per cent. That’s modest relative to historical experience but also well above current expectations.

Here’s a brief summary, drawn from my experiences as an observer and investor from the 1950s to the early 1990s, of how inflation can affect investment decisions and investment returns.

The economy

Inflation — particularly when it’s higher than is generally anticipated — usually has negative effects on the economy.

Inflation shortens investment horizons and encourages speculative investments. The inevitable “leads and lags” in the inflation process make it hard for businesses and households to identify and respond to changes in relative prices.

Governments and central banks too often take action too late in the piece. As a result, inflation accelerates, and interest rates have to increase markedly.

Inflation widens inequalities in the distribution of income and wealth — particularly when, as happened in the 1970s, inflation morphs into stagflation (slow growth accompanied by inflation).

Interest rates 

Interest rates move higher as inflation increases. But bond prices vary inversely with interest rates: when inflation rises, and investors usually face capital losses, particularly on medium-dated and longer-dated bonds, when bonds are sold prior to their maturity dates.

Also, rising inflation causes the “real” (or after-inflation) income received from existing holdings of bonds to decline. Real returns can quickly turn negative. At time of writing, the nominal yields on 10-year government bonds in the US and Australia were 0.7 and 0.8 per cent respectively.

When inflation re-emerges, investors still need to hold safe assets, but will have to focus more on short-dated bonds, quality floating rate investments, positive return bond funds and inflation-linked bonds issued by the federal and state governments.

Shares

Investors need to allow that sustained increases in inflation and interest rates generally result in shares trading, on average and over time, at lower price-earnings multiples relative to the valuations we see in the times of low inflation.

But history also suggests that a modest increase in inflation from a low level is initially positive for shares, because it’s somewhat easier for companies to widen margins. When inflation moves up another step or two, share prices are more likely to lose, as investors worry central banks could bring on higher interest rates and a credit squeeze.

Property

Average property prices generally rise as inflation steps up from low to moderate. However, when inflation moves higher still, investor interest in property is likely to surge for a time, encouraging some investors to take on too much debt (especially debt with variable interest rates), and suffering the painful consequences when governments and central banks finally get around to bringing inflation under control.

Don Stammer is an adviser to Stanford Brown Financial Advisers. The views expressed are his alone.

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