posted in: Building Wealth
What is inflation and how can investors benefit from it?
It’s official – inflation is on the rise. So, how will this affect the economy, wages, interest rates and asset values? Let’s take a closer look.
What is inflation?
Inflation measures the increasing value of goods and services and the corresponding decreasing purchasing power of your money over time. For example, in 1970 $20,000 would have bought you an average Sydney home, whereas today you’d be lucky to purchase a car for $20,000! Inflation is measured by taking the values of a number of goods and services across an economy such as food, housing, petrol, etc and measuring movements in value across all of those goods and services. The measurement of these goods and services in Australia is called the Consumer Price Index or more commonly referred to as the CPI.
Is inflation on the rise?
The CPI rose 1.3% to 3.5% in the December 2021 quarter (after a high of 3.8% in June 2021). Looking at the trimmed mean annual inflation, which excludes large price rises and falls, inflation increased to 2.6%, the highest levels since June 2014.
This pattern follows what’s occurring globally. The U.S. consumer price index (CPI) rose 0.5% in December 2021 compared with November and 7% compared with December 2020.
In Australia, the most significant price rises in the December 2021 quarter were for new property dwellings by owner-occupiers purchasers (+4.2%) and Automotive fuel (+6.6% – a 14 year high). Construction materials, timber, iron ore, housing, used cars, furniture, fruit and vegetables have all also increased significantly.
What’s caused the rise in inflation locally and globally?
There has been a perfect storm of factors contributing to the inflationary environment. Ultimately it comes down to supply and demand.
Supply of certain goods and services has been restricted by major supply chain issues triggered by the pandemic. This has created shortages resulting in demand outstripping supply. This has especially been evident in markets such as the second hand car market, which has seen many second hand cars either retain or increase in value due to the lack of new cars arriving.
Additionally, there has been a lot of money pumped into the financial systems through State and Federal Government stimulus packages such as JobKeeper or Homebuilder. This situation has resulted in people and businesses having more money to spend, hence pushing up demand and then ultimately prices. Combined with record low interest rates, an increase in savings during COVID, and an increase in spending, inflationary pressure across many goods and services are starting to take hold.
What about wage growth?
We saw a modest increase in the Wage Price Index (WPI) of 0.6% in the September 2021 quarter, which comes off the back of very little movement in wages over the last two decades. However, with overseas borders just opening now following two years of closures this has created increased competition for talent in certain sectors and has resulted in significant wage growth in those sectors.
For those sectors which typically rely on bringing in talent from overseas such as technology and professional services, we’ve seen salary increases in the last couple of years in excess of 20%. For example, an intermediate accountant at a mid-sized suburban accounting firm will now earn $90,000 compared to $70,000 two years ago (an increase of almost 30%). Other professional services roles such as investment bankers, lawyers, marketing executives, accountants, construction managers, sustainability and risk specialists, specialists in data analytics, cyber security, artificial intelligence and robotics are all in high demand and are seeing an increase in the average wage.
Other industries may be experiencing short-term labour shortages due to COVID-19 absences. For example, many restaurants have cut back their bookings or reduced their opening hours or days due to the lack of working holiday makers that would traditionally take up part-time roles in hospitality.
Outside of pandemic related pressures, we also have an ageing population which has changed the proportion of workers to consumers, which is another factor influencing the competition for talent.
However, wage growth doesn’t always take place equally across each industry. Industries with severe labour shortages with salaries set by commercial pressures have had faster wage growth, whereas other industries such as teachers or nurses with locked in increases have a lot less flexibility for immediate growth.
What impact will inflation have on the economy?
It’s been a long time since Australia has experienced a true inflationary environment. For many, it will feel unfamiliar. Here’s what we can expect.
Interest rates may rise sooner than anticipated. Originally the RBA was predicting a 2024 cash rate increase. Now it feels probable that this will occur much sooner.
The value of savings will diminish – those keeping their money in a savings account will suffer losses as interest rates aren’t keeping up with inflation.
Asset prices usually keep up with inflation, but property price growth at the moment is actually ahead of inflation. In the case of property, price rises in some markets have been triggered by the unique conditions of the pandemic (for e.g. regional Australia) so this may not last and other markets are already starting to slow down (e.g. Sydney) so it’s important to keep in mind that each market won’t perform the same.
One of the major risks of uneven wage growth is a two-speed economy where some do well and others struggle. An inflationary environment doesn’t have as much of an impact if your salary has increased and you have investments that are also going up in value. However, if your salary hasn’t increased, the cost of living can become much more challenging.
When it comes to the share market, modest inflation and wage growth can be good for share prices. However, unexpected or very high inflation can be looked on as a negative by the market due to increased borrowing costs, input costs (materials, labour) and lower purchasing power.
What opportunities are there for investors?
Savvy investors will be able to identify and leverage opportunities in an inflationary environment. With more money in the system, it will drive additional investment which will subsequently increase asset prices. Those investors with larger investment portfolios tend to perform better with rising asset values, especially while those assets grow ahead of inflation.
Those experiencing wage growth will be in a good position to invest as they can potentially borrow more, which could assist them to increase their investment into assets such as direct property. For example, someone who’s experienced a 30% increase in their salary might be able to now upgrade their home or purchase an investment property, which could be worth hundreds of thousands of dollars over the coming years, assuming asset values continue to increase.
We can also expect to see the barriers to entry increase over time as inflation takes hold, such as rising interest rates and additional borrowing restrictions to curb asset growth. So, of course, investors still need to exercise caution. With interest rates set to rise in the near future, it always makes sense to have a buffer in place to ensure you can afford rising repayments and costs. For those investing in the share market, it’s important to keep an eye on how the market is reacting to inflation. The best bet is always to invest for the long term.
*NB at the time we are writing this article, Russian forces have just entered parts of Ukraine, which many experts believe will drive up energy prices as Russia has large stores of oil and natural gas. This will only create further inflationary pressures worldwide.
Want guidance on your investment strategy in an inflationary environment? Get in touch with us for a free consultation to bolster your financial position in 2022 and beyond.