Inflation: What is it and how does it affect investments?

By Cutcher & Neale Accounting and Financial Services - May 09, 2022

One of the more common investment terms discussed in markets currently is inflation. But what is inflation and why is it such a talking point?

Inflation is an increase in the level of prices of the goods and services that each of us purchase. It is measured as the rate of change of those prices. Typically, prices versus the same time a year earlier.

The most well-known indicator of inflation is the Consumer Price Index (CPI). In Australia, the CPI is calculated by the Australian Bureau of Statistics and published after each quarter.

Australia’s recently released CPI data highlights inflation is well and truly on the rise. The March quarter CPI reported an underlying inflation rate of 3.7%, which is the highest annual inflation rate in more than 20 years. This is the first time since 2010 that core inflation has breached the Reserve Bank of Australia’s target inflation rate of 2% - 3%.

Inflationary pressures have been a significant talking point this year, with COVID-19 related supply disruptions and Russia’s invasion of Ukraine fuelling increased costs. While on the other hand, demand from cashed up consumers coming out of lockdown restrictions has been pushing prices up, as demand for goods is strong, allowing businesses to charge more.

For a real-life example, look no further than a recent move from SPC Global. The owner of SPC brands, including baked beans and spaghetti, Ardmona tomatoes and Goulburn Valley fruits, announced in March price rises of 10% - 20% across its products in order to deal with underlying rising costs, from higher energy, fuel, transport and raw materials.

From an investment point of view, inflation requires careful consideration across different sectors. With regards to investments on the share market, inflation that rises modestly is generally seen as a positive for the broader market, given it is consistent with an economy growing at a sustainable pace.

However, when inflation rises significantly, it is generally seen as a negative for stocks, as the associated increased borrowing costs, higher costs of materials and labour, along with reduced expectations of earnings growth, all combine to put downward pressure on stock prices. However, businesses in certain sectors such as Consumer Staples, Materials and Health Care often find it easier to negotiate higher inflationary environments as they tend to have a better ability to pass on higher prices to customers.

The best ammunition against high inflation is the ability to raise interest rates. In order to maintain economic stability, central banks, in our case the Reserve Bank of Australia, typically lift interest rates to moderate any radical movements in price. By increasing interest rates (borrowing costs), this discourages consumer and business spending, in turn, slowing growth and demand for goods, reducing inflationary price pressures.

If you would like to discuss your investment options, please do not hesitate to get in touch with our team.

 

Contact us