Jarden Wealth Weekly: How Inflation Affects Your Investments

Inflation is the term that describes the general increase in the prices of goods and services over time. It also means that the purchasing power of money is decreasing. For example, according to the Reserve Bank of New Zealand (RBNZ) inflation calculator, $1.00 in the first quarter of 2000 had the same value as $1.85 in June 2024. This means that inflation has reduced the value of a dollar by 46% over 24 years, at an average rate of 2.6% per year.

But inflation can also fluctuate wildly over time. This year, inflation rose to 4.6% per year, the highest level in decades. Between March 2020 and June 2024, prices rose 20.9%, meaning what $1 could buy fell 17.3% during that period.

What impact does inflation have on cash investments?

Inflation negatively affects cash investments, such as money under your mattress or in a bank account that doesn't pay interest.

To maintain and ideally increase the value of your investments and their purchasing power, you need to invest in assets beyond mere cash. Bonds (and term deposits), for example, are a type of investment where you lend money in return for regular interest payments and repayment of the invested capital when the bond matures. The interest income generated should cover the effects of inflation and compensate you for the risk that the borrower will not pay the interest or capital on time.

Of course, if you spend all the interest income you receive, the purchasing power of your investment will decrease over time. This is more relevant for long-term investors such as charities who need to preserve and preferably increase the inflation-adjusted value of their investment capital.

Interest and bonds

Interest rates are affected by inflation. When inflation rises, the RBNZ usually raises the official policy rate (OCR) to reduce demand in the economy and thus lower inflation. On the contrary, when it lowers the OCR, it is intended to stimulate demand in the economy.

When interest rates rise, bond prices fall, and when interest rates fall, bond prices rise.

For example, if you had invested in a five-year bond in September 2020 when interest rates were extremely low, selling now would result in a loss due to higher inflation and higher interest rates. In addition, the inflation-adjusted value of your principal at maturity would have declined, meaning you would not have been adequately compensated for inflation over the life of the bond.

However, if you had purchased a five-year bond in September 2023 when interest rates were high, the subsequent falling interest rates and inflation expectations would give you a gain if you sold the bond today. By the time the bond matures and the principal is repaid, you would likely have made a profit, adjusted for inflation.

The role of inflation for stocks and other assets

The effects of inflation on stocks are more nuanced.

Generally, stocks perform well in an environment of low interest rates, low, stable inflation, and good sales and earnings growth rates. However, these conditions do not always hold. Higher inflation ultimately leads to higher interest rates and can cause consumers to spend less and banks to be more restrictive when granting loans.

Higher inflation can hurt corporate profits in several ways: it can increase costs, reduce demand, and lower valuation multiples. Investors should therefore look for companies that can maintain their competitiveness and pass higher costs on to customers without losing market share. These include utilities, large technology companies, companies with well-known brands, companies in expanding markets, and those where demand exceeds supply and that have effective control over their costs.

Comparison of inflation hedges – gold versus stocks

Many investors use gold as a hedge against inflation, but the effectiveness varies. Gold is more of a hedge against economic shocks or currency devaluations, especially when a country prints more money without increasing production. The recent rise in gold prices can be attributed to several factors, including the fact that central banks bought more gold to diversify their reserves away from US dollar-based assets. Over the long term, however, gold has only produced a slightly positive inflation-adjusted return per year.

According to economist Professor Jeremy Siegel, stocks have historically produced the highest inflation-adjusted returns. His research shows that stocks have consistently outperformed bonds and gold in real terms, offering higher returns and preserving purchasing power.

However, all of the above factors exceeded the value of a $1 coin, which had a negative inflation-adjusted return and whose purchasing power declined significantly.

Final thoughts

While cash may seem like a safe investment in the short term, it can be risky in the long term as inflation erodes its purchasing power. Holding cash can put you at risk of losing your purchasing power and missing out on opportunities the market offers.

That's why it's important to invest in and hold growth assets like stocks and real estate, as long as your risk tolerance allows. These investments can help you preserve and grow your wealth, and they provide you with income streams that can grow with inflation.

Jarden Wealth Limited is a NZX advisory firm. A financial advice disclosure statement is available free of charge at jarden.co.nz/our-services/wealth-management/financial-advice-provider-disclosure-statement/.

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