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Inflation - how does this affect your investments

Inflation and your investments

We have had low inflation since the 1990’s and it is easy to forget how inflation can eat away at your investment assets. 

Real rates of return
The key concept is the ‘real return’.  When inflation rates are 1.00 – 3.00% - you don’t need to get particularly high investment returns to get a positive after tax, fees and inflation return.
In our retirement savings analysis modelling for clients, we model how long money will last in retirement based on after tax, fees and inflation returns of 1.00%, 1.50%, 2.00% and 2.50%. In the benign inflation environment of the last decade, our clients portfolios have been tracking along or above the 2.00% after tax, fees and inflation line.

Working backwards, if there is a tax rate of 17.50% (ie no income other than NZ Super earned in retirement) fees (after tax) of 1.00% and inflation of 2.00%, a 2.00% after tax, fees and inflation return translates to a headline return of just over 6.00%.  Quite achievable.

When inflation increases quickly and by a large amount (as it has in the last year), the equations change.  To get that same 2.00% after tax, fees and inflation return, you need to get a headline return of 12.00%.  As you can ascertain – not achievable without taking on a very high amount of risk, and high rate of risk of capital loss).

It is anticipated that inflation will return to being in the 1.00 – 3.00% range by the end of 2023 (as long as we don’t get into a price inflation/wage inflation escalation), which indicates that these inflation spikes may be transitory. 

When that happens, the key is to remember that your investments and modelling are long term, you can’t always expect to get an after tax, fees and inflation return that is positive (although we have for a decade on average).  There may be a year or two where the real returns are lower or negative – which mean that you have to assess the long term real rates of return on your investment portfolio and remember that you are a long term investor.

Savings in the bank and Term Deposits
Cash, or term deposit investments commonly provide investors with a negative real rate of return.  Assuming a marginal tax rate of 17.50% (as above), here is a summary of the real rate of return of a 1 and 2 year term deposit over the last three years.


Term Deposits                       Headline Rate           Inflation          Real Rate of Return
2 year at 31/03/2022             2.74%                          6.90%              -4.64%
1 year at 31/03/2022             2.44%                          6.905               -4.89%
2 year at 31/03/2021            0.98%                          1.50%              -0.69%
1 year at 31/03/2021            0.93%                          1.50%              -0.73%
2 year at 31/03/2020            2.42%                          2.50%              -0.50%
1 year at 31/03/2020            2.38%                          2.50%              -0.54%
Although term deposits often provide a negative real return, it is important to hold some cash or cash like (TD’s) investments in your investment strategy, to provide a store of wealth and diversification. 

However, holding money in these investments isn’t going to make you rich, you need to diversify your investments into assets that will give you a positive real return, usually shares and property.

Shares
Investing in shares (equities) provides you with an investment in future cashflows from a company.  The best companies to invest in are those that are actually producing things or services and making a profit.  Some investors like the speculative aspect of investing in new start ups and companies that should make a huge profit in the future, but this isn’t a core approach of Moneyworks investment recommendations.

Over the medium and long term, investments in shares will retain their value as companies can increase their prices to reflect the higher costs of the inputs created by inflation.  However, in the short term when there are sharp increases in inflation, share values may well stagnate or fall, as prices (and profits) can’t keep up with the unexpected and unplanned prices of the inputs.

This has occurred when the initial covid bump settled down, as supply chain delays have affected delivery of components, and in particular as freight costs have escalated significantly because of increased demand for things, and limited effective freight capacity (because airlines are not flying as often, and ships are stuck at sea waiting for ports to open because of Covid lockdowns).

Something to take into account are how many companies are now technology and service based, and how inflation affects their profitability (when many of their inputs are labour, and compliance costs as compared to product).  Along with that point is the consideration that as more services move to the cloud, costs of service providers are continuing to fall.

To have a successful investment portfolio over time, you need to have a diversified exposure to shares, and acknowledge that from time to time you may not get consecutive years of real returns on these investments.

As is the case all the time – it is extremely dangerous (and likely not effective) to exit shares and put your money in the bank, waiting for the inflation to die down.  Remember, cash and term deposits are fixed in their returns, and can’t increase their prices to adjust for inflation, and it is pretty much impossible to ‘time’ getting in and out of the markets at the right time. Just ask anyone who sold out in March 2020 in the Covid crash, only to see markets come roaring back.

Property investments and mortgages
Investing through an investment adviser will provide you with investments in wholesale, retail and commercial properties. 

Over the long term, these too will provide you with a real return, but will also lag in the short term when there is unexpected inflation, because the income on the properties is contractually agreed through a lease agreement.  These agreements usually have clauses that will ensure that the income paid to the property owner will increase with inflation and other factors at each rent review period.  But if a rent review has just happened and then there is sudden inflation, you can see how there could be lower returns for a while.

Investing in residential property raises different issues. 
In New Zealand we have seen the capital value of properties increase significantly in recent years, and the basics of property investing (investing for rental income) have been forgotten, as current policy settings seem to guarantee that house prices will not fall in any meaningful way in the near future.

The key financial factor that impacts on your residential rental property investment is the interest payable on any mortgage associated with the property.  Historically interest payments have been tax deductible, but with the recent policy changes, the amount of interest that is tax deductible for existing properties is reducing annually from March 2021 until March 2025 – when it will be nil (apart from on new builds).  This means that the amount of mortgage interest being paid has a real impact on the return from the property.

For any rental properties purchased since March 2021 there is no interest tax deductibility (apart from for new builds).

Around half of the mortgages in New Zealand are due to come off their fixed rate terms in the next year.  Mortgage rates have increased from below 2.00% (for a brief period), to well over 6.00% for 3 year, 4 year and 5 year lending (depending on your bank).  Headline 1 year mortgage rates are now between 4.49% and 5.15% and 2 year rates are between 5.25% and 5.85% with mainstream lenders.

That increase of between 2.50% and 4.00%+ has a direct impact on the pockets of the residential property investor.  The shortfall between the rental income received (and there are new rules that mean that you can only increase this income once a year), less rates, insurance, and maintenance – which could once have been manageable out of an investors earned income, now include the higher mortgage interest rate payments that have to be paid from somewhere.

If you are part of the 50% of fixed interest rate mortgage holders that are due to refix your mortgages in the next year, it may be worthwhile refixing for between 12 months and 2 years.  This is assuming that inflation will come back down again at the end of 2023, and with it interest rates.  But there are no guarantees.  Make sure that you do your research as to what the most suitable refix term is for your personal situation.



 

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