Protecting Against Inflation

Inflation can be really nasty. Those of us who can remember the 1980’s in New Zealandknow that inflation was high, running at close to 20%. We can also remember wage freezes, and the maximum interest rates that were chargeable on mortgages. Inflation is something that all investors should worry about.

Since the de facto gold standard established under the Bretton Woods Agreement in 1944 was abandoned in 1971, the global economy has for most of the time experienced inflation. During the recent Global Financial Crisis, global share prices plunged by 54%, and the housing and property market collapsed, yet inflation rates for food and household energy rose 5.29% and 3.95% per annum over the past five years. This equates to a20% to 30% increase in what are bare necessities.

For investors who are likely to be in retirement for typically around 20 years, they need to ensure that their portfolios are positioned to withstand the impact of inflation. As a reaction to the backlash of losses that have occurred in finance companies, property and shares, many investors are overweight in cash. That may be fine in the short term, but it is hopeless in the battle against inflation over the longer term. If you deduct tax off the short term interest rates that are currently available, the chances are that the net return will be less than the inflation rate.

There are ways to inflation proof a financial plan. These include decreasing the duration (length of time to maturity) of bond portfolios by avoiding over exposure to long term corporate bonds. Many corporate bonds are being sold with durations of five to seven years. On an after tax basis, even a bond paying 7.5% per annum pre tax is unlikely to be keeping pace with the impact of inflation. Shorter maturity bonds (invariably “second hand”) with only one to two years to maturity may be a better option. An even better option may be to utilise a bond fund which employs a hedging strategy which can convert fixed interest rates into variable interest rate bonds and benefit from future rises in interest rates. This effectively means that investors who hold securities with shorter maturities have the opportunity to reinvest at higher rates more quickly.

Inflation protected bonds should also be considered. These guard against inflation in addition to paying a fixed rate of interest. The principal (or the amount originally invested) increases with inflation. These are offered by the New Zealand Government, and indeed by a number of Governments around the world. Again some funds have an exposure to inflation protected bonds.

Some shares also effectively protect against inflation. Around half are negatively impacted. A portfolio comprising high stable dividend yielding shares such as water, power and gas utilities, or infrastructure assets such as ports and airports will tend to protect against inflation. Most monopoly type companies have the right to increase prices by the rate of inflation. These do tend to be regulated, but they provide a good safeguard for investors.

It is well known that commodities overall also protect against inflation. However there is a lot of price volatility being around twice that of the share market which limits the usefulness. Some commodities investments in order to provide capital protection have investors locked in for five to ten years. Inflation over that time period may erode half the capital value.

And finally there is property. This tends to increase in value at slightly more than the rate of inflation over the long term. It is highly illiquid, and invariably when you need to sell it, the market is weak.

Overall to protect against inflation, a well diversified portfolio, with a good exposure to the inflation protectors as mentioned, should be considered. Professional advice over what is suitable for your circumstances should be taken.