There has been a lot of debate about inflation in recent times. Is the inflation we’re seeing transitory or structural and what impact can it have on equity markets? Read on to learn more about how our financial planners view investing during inflation.
Inflation is the increased rate of prices on a basket of selected goods and services in the economy. Put another way it is a decline in the purchasing power of money over time. The rise in the price of these goods and services (inflation) means your dollar will buy less than it did in prior periods of time (purchasing power). Have you ever heard of the saying $1 today is worth more than $1 tomorrow?
When the economy is not running at full capacity, inflation is theoretically required to lift levels of production. The increase in demand translates to more spending which creates jobs improving the overall welfare of the economy.
Too much inflation however is not good on share markets. Long-duration assets like the Big Tech firms in the US have been impacted the most as inflation is increasing. The future value of their cash flow is worth less today in a high inflationary environment, hence the drop in market valuation, ie share price. A company that can pass the impact of inflation on to their customers should perform better in this market.
Share markets are very resilient to change in inputs to pricing models and external shocks over the long term as the below chart from Vanguard demonstrates. The Australian market has experienced an average 9.2% return over the last 30 years despite the dot com boom and bust, the GFC, and more recently COVID.
Ups and downs are all part of investing, and it is important to not overreact to inevitable short-term market movements. Importantly, not being placed in a position where you need to exit your investments is the secret to truly capturing the long-term returns share markets provide and the distributions and dividends, they continue to pay whether the market is up or down.
Investing in companies that can generate cash and set aside part of this towards improving and growing the business, and part as a dividend, allows investors to receive the maximum ongoing benefit of being invested. Over time this can provide a natural hedge against inflation.
In fact, over the last 35 years, the ASX200 index has returned an average of 5.7% per annum in dividends, versus inflation of 2.8% per annum. This has allowed investors to increase their purchasing power, despite inflation eating up some of the dividend.
In a classic piece for Fortune magazine in 1977, Buffett outlined his views on inflation. We believe they hold true today: “The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislatures. The inflation tax has a fantastic ability to simply consume capital. … If you feel you can dance in and out of securities in a way that defeats the inflation tax, I would like to be your broker — but not your partner.”
Long term investing in markets and not putting yourself in a position that you have to sell, coupled with the natural hedge of dividends, is a great tool to beat the impact of inflation.