Inflation is one of those words that a whole generation has been able to largely ignore. Until now.
With inflation in the US now at about 8.5% and 7.5% in Europe[1], and the Reserve Bank of Australia forecasting our underlying inflation to increase to around 6% in the second half of 2022, just what is inflation and how does it affect you?
According to the International Monetary Fund, inflation measures how much more expensive a set of goods and services has become over a certain period, usually a year[2]. In simple terms, inflation signifies a rise in the price of goods and services, meaning you pay more for every purchase you make.
Does an increase in the inflation rate overseas influence Australia’s inflation rate?
It is not a surprise that countries in today’s world are more connected than ever before. Therefore, a rise in overseas inflation rates will impact the Australian economy too, particularly relating to the cost of imports.
However, the degree and timing of its impact will vary. For example, a rise in labour costs in the US may have a limited direct impact on Australians; however, an increase in the price of iPhones or Nike shoes in the US will reflect in their price in Australia too[3].
Markets also no longer see inflation as a transitory issue amid higher wages growth and increased supply pressures. Most countries have experienced higher inflation throughout the past year, and that has seen central banks reverse policy and governments wind back their spending.
What will be the impact of rising interest rates and inflation on Australia’s economy?
Interest rate movements made by the US Federal Reserve Bank (the Fed) are closely monitored by central banks worldwide, including the Reserve Bank of Australia (RBA). In recent times, many developed economies, including the US and Australia, have reduced interest rates to boost their economies. With rates nearing all-time lows, there is an expectation that rates will increase due to the strong performance of those economies. Quite often when the Fed increases its interest rate, Australia is quick to follow suit. As interest rates rise, the cost of borrowing funds (home loans, business loans, personal loans, etc) will increase. This in turn leads to a further rise in the inflation rate, making goods and services even more expensive. Rising inflation rates can also negatively impact the Australian dollar, where one AUD buys less than it may have done previously.
This can negatively affect individuals’ capacity to save money, especially if their income does not rise by the same rate as inflation.
What will be the effect on investors?
High inflation and high interest rates are game changers for investment portfolios[4]. Disinflation has persisted for much of the past four decades leading to a favourable investment environment for risk assets. However, a rise in interest rates and borrowing costs will negatively impact share prices and lead to large fluctuations in the prices of those shares. In addition, future returns are likely to be lower as markets tend to put a lower valuation on shares as interest rates rise.
For mum and dad investors, rising interest rates mean paying more interest on their home loan, which reduces their disposable income and, in turn, reduces their capacity to invest. Growth in share prices can be volatile, meaning it will take them longer to build wealth.
Those near or in retirement would be particularly sensitive to inflation due to their reduced spending power and increased vulnerability to a sequencing risk event. For retirees, an increase in the price of goods and services at a time of share market volatility can lead to having to sell more of their investment assets (potentially at a loss or reduced profit). Also, there could be uncertainty in dividend income, which many retirees often rely upon. Retiree investors will have fewer years to recover from a drop in their portfolio value compared to younger investors.
The risk of structurally higher inflation and a more volatile and lower returning investment and economic environment may be upon us whether we like it or not[5].
How should you prepare for a rise in inflation?
- It is important to first analyse your personal cashflow situation to understand where your money goes.
- If you have a variable rate home loan you have not looked at for a while, you may consider changing to a fixed rate for at least part of your home loan to limit your exposure to rising interest rates. Be aware that the market has already started to price in potential rises.
- Reconsider new personal loans, such as car loans. Do you need to take on new debt when interest rates are likely to increase?
- For the risk-taking investor, it can be tempting to invest more money into shares when prices are falling, but always consider averaging your position to avoid market timing risk.
- For investment purposes, consider having exposure in well established companies, “blue chip stocks” vs riskier stocks. Investors often find comfort knowing their funds are exposed to good quality companies with strong balance sheets.
If the thought of rising inflation leaves you feeling unsettled, be sure to talk to a professional adviser. Your adviser will review your financial position, and your ability to meet your financial obligations, as well as identify strategies to outpace inflation.
Advisers work towards a robust investment and portfolio construction philosophy, consistently applied, proven through a range of economic cycles, and supported by a decision-making framework that can quickly adjust portfolios in response to inflation, while also understanding the needs and goals of you as a client[6].
The information contained in this article is general information only. It is not intended to be a recommendation, offer, advice or invitation to purchase, sell or otherwise deal in securities or other investments. Before making any decision in respect to a financial product, you should seek advice from an appropriately qualified professional. We believe that the information contained in this document is accurate. However, we are not specifically licensed to provide tax or legal advice and any information that may relate to you should be confirmed with your tax or legal adviser.
[1] https://www.fsadvice.com.au/blogs/are-you-ready-for-what-s-coming
[2] https://www.imf.org/external/pubs/ft/fandd/basics/30-inflation.htm
[3] https://www.afr.com/policy/economy/us-inflation-pressures-australian-interest-rates-20211111-p597zx
[4] https://www.fsadvice.com.au/blogs/are-you-ready-for-what-s-coming
[5] https://www.ifa.com.au/news/30627-why-advisers-need-to-prepare-for-higher-inflation
[6] https://www.ifa.com.au/news/30627-why-advisers-need-to-prepare-for-higher-inflation