Why inflation matters for SMSF portfolios
The Reserve Bank of Australia (RBA) has a mandate to keep inflation within a 2% to 3% target band over the course of time.
There are a number of ways of looking at inflation. The number for inflation often quoted is the headline number but the main measure of inflation the central bank uses when making interest rate decisions is called underlying inflation.
Given how central inflation is to the economy, it’s important for self-managed super fund (SMSF) investors to understand what it is and how it affects investments.
As Diana Mousina, Economist, Multi-Asset Group, AMP Capital explains, underlying inflation doesn't take into account very high price rises or falls over a period.
For instance, underlying inflation is moderated for volatile items like petrol and fruit and vegetable prices. This allows consistent readings for core inflation, which is the central bank’s main concern.
“The data for the first quarter of this year showed underlying inflation rose to 1.8% over the year, up from 1.5% in the previous quarter. The pressures that caused Australia’s low inflation environment over the past two years are abating, but 1.8% is still below the RBA’s target,” says Mousina.
Higher health prices in the first quarter as a result of the pharmaceutical benefits scheme were a factor behind the lift in inflation in March.
“Higher petrol and electricity prices also caused an increase in the March quarter,” she explains.
However, underlying inflation is still low in the Australian economy and it’s not expected to rise sharply in the near term.
Says Mousina: “We still see it rising over the next two to three years, but we’re not expecting any one-off impacts that will suddenly push it back up to more than 2.5%.”
Higher electricity prices and the impact of Cyclone Debbie on certain food prices such as tomatoes may contribute to higher inflation this year. AMP Capital forecasts the disaster could add up to 0.2% points to headline inflation in 2017.
These factors aside, there are still plenty of downward pressures on consumer prices at the moment as well.
“Low wages and spare capacity in the economy and labour market will also keep a lid on inflation,” Mousina explains.
Impact on investments
Real returns, which are total returns minus the rate of inflation, are the critical factor to understand when it comes to the effect of inflation on investments.
“Normally, inflation should be in line with the central bank's target to generate stronger economic outcomes. But when inflation is below trend, real returns may be higher than they otherwise would be, depending on the nominal rate of return,” says Mousina.
“So it’s important for SMSF investors to keep a close watch on real rates of return, and also real wages growth as the main driver of income growth,” she adds
Ideally for SMSF investors to keep growing their wealth, real rates of return should be rising. If they drop or plateau, living standards and purchasing power will remain flat, which will reduce investment returns.
If the nominal rate of return is above inflation, but the latter is still relatively low, investors should benefit from a positive rate of return.
“We are not expecting the Reserve Bank to change the cash rate in the near future. While a low inflation outlook means that the RBA could cut interest rates again, we believe the board remains concerned about inflated housing prices, in Sydney and Melbourne particularly, and very high household debts. So the bank is likely to sit on the sidelines for now and keep the cash rate at 1.5%,” says Mousina.
There are protection mechanisms if inflation is a concern for SMSF investors. Inflation-linked bonds are the main tool investors use.
These are fixed-interest instruments whose returns are linked to the inflation rate, helping investors to protect their portfolios from movements in the inflation rate.
While inflation is reasonably benign at the moment, it does rise and fall depending on economic conditions. For instance, inflation reached a high of 23.9% in 1951 and fell to a low of -1.3% in 1962. The average figure is 5.07%.
Given these parameters, it’s important for SMSF investors to understand how inflation works, and how to protect their portfolios in case it rises sharply, to maintain protect investment values and portfolio returns.