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Friday, 20 May 2011 05:50

Investing is a rising inflationary environment

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The Reserve Bank has a formal inflation target in place and most investment commentators regularly talk and discuss the threat inflation may have on investors.  This article explains why inflation should be considered by investors and some tips on protecting an investment portfolio in a rising inflationary environment.

For many years there have been deflationary pressures, particularly from 1. an increasing Australian dollar which lowers the cost of imports, and 2. cheap Chinese labour (translating to cheap imports).

In the past 12 months, Chinese wages have increased 30% for average workers, while Chinese construction workers have received about 100% wage increases (source Platinum Asset Management).  Food and energy shortages around the world are also putting upward pressure on prices of basic essentials for daily living.  We believe that the days of deflationary pressures are over for now.

Why is this important?

Consider a business that sells widgets.  It sells 1,000 widgets for $100 each, while the cost to produce the widgets is $50 per widget.  The gross profit for this business is therefore $50,000.

If however the cost to produce widgets due to rising energy prices, increased wages etc goes up to $60, the gross profit falls 20% to $40,000.  Of course the business could raise the sale price of widgets to protect their profits, or sell more widgets if the market will bear, but this is easier said than done. So inflation hurts business profits (read share prices) as well as making the cost of living higher.

What typically happens to interest rates when inflation rises?

History suggests that when inflation rises, interest rates rise.  Below is a chart sourced from the Reserve Bank of Australia that shows the movements of inflation (top part of the chart) and interest rates (referred to as cash rate in green line) over the past 25 years.  You can see how they move closely together.

With these points in mind here are some simple techniques to help you inflation proof your portfolio:

Share Market Investments

Seek to invest in companies that have the ability to pass on price increases to their customers.  These companies typically have the following attributes:

  • Well recognised brand and a dominant market position  (meaning they can pass on increased costs)
  • Management with experience from previous inflationary cycles

If using managed funds, ensure that the fund manager responsible for investment selection is on top of the threat of global inflation.  Evidence of this could come in the form of commentary from the fund manager in recent communications.  Your adviser could also have direct contact with the fund managers’ investment personnel and can confirm this for you as well.

Fixed Interest Investments

Exercise extreme care when investing in long dated fixed interest investments.  Consider an investor who invested $100,000 into a 10 year bond paying 5% interest.  Interest received is $5,000pa.  If interest rates rose to 10%, in order to receive $5,000 of interest the investor would only require $50,000 of capital.  The point here is that if this investor wished to sell their 10 year bond, before the 10 year period was due, it would be unlikely that they would receive anywhere near $100,000.  It is possible to lose capital in fixed interest investments in a rising interest rate environment.

Instead, look at fixed interest investments that are linked to interest rates.  So as interests rates go up, the payment received goes up as well.  Your financial adviser can help you with investments that have these characteristics.

Other suggestions

Property (particularly commercial property) can provide protection in an inflationary environment as lease agreements normally contain an inflation adjustment each year.

Infrastructure investments such as toll roads also contain clauses in the legal agreement, where the toll paid by consumers is increased by inflation each year.

Talk to your adviser to ensure that your portfolio is prepared for the threat of a global inflationary environment.

Read 757 times Last modified on Friday, 20 May 2011 05:50
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