By David Curmi
It’s been quite a while since investors have had to deal with the reality of inflation. We have been fortunate that for many years levels of inflation have been contained within the 2-3% range. Not so this year. Eurozone inflation in November climbed to a year-on-year rate of 4.9%, its highest rate for the last 25 years. This spike has been fuelled primarily by supply chain disruptions and, in particular, a rise in energy costs.
We are now entering new territory for many investors. Investors save money to build a retirement pot. A pot that is designed to provide them with income to finance their retirement years. Inflation eats away at this retirement pot. It does this in two ways. Primarily it will erode the value of your euro such that, for example, €1 in 10 years’ time will buy you significantly less than what it will buy you today. Think about it. If your money is invested to achieve a return of net 3.5% p.a. and inflation is 4.9% p.a., the real value of your money is falling by 1.5% p.a. The way to counter this is by either investing into securities that will give you a return above inflation, or by saving more. Both need to be considered very carefully as the implications can be severe. Alternatively, if you keep the status quo, it will take you longer to achieve the desired level of retirement pot, implying that you will have to retire later in life.
Our ability to save more may however be also impacted by the rise in costs that inflation brings with it. Inflationary pressures have brought about a rise in costs of many items, from food to consumer goods to eating out. The increase is quite discernible. It certainly is in our household. In many cases this increase will negatively impact your ability to save the required amount to make up for the higher inflation as you are spending more on your day-to-day needs.
Central Banks are also having to grapple with the arrival of inflation. Whilst for many years central banks have provided significant stimulus to economies, both in the form of keeping interest rates low, and in some cases negative, as well as through their various bond buying programmes, these are now set to reverse. Only yesterday Federal Reserve Chairman Jay Powell gave the clearest symbol yet that the reversal of all the assistance central banks have provided to economies is going to happen quicker than originally anticipated. Interest rates are expected to be hiked at least twice in 2022. Whilst Europe is on the same trajectory it is quite a way back. Interest rates in the Euro area are not expected to be changed during 2022. However, bond markets, especially government bonds are already beginning to position themselves for such increases. This will mean that bond prices will fall.
This may not all be bad news, especially for those investors who have long built their nest egg and find it difficult to achieve the desired level of income to fund their lifestyles. The spectre of zero interest rates on bank deposits will very slowly reverse itself whilst one would expect yields on government bonds to become more attractive in time.
The extents to which these adjustments affect markets will depend largely on the permanency of inflation. There are strong arguments to suggest that the spike in inflation being seen is transitory. This is because some of the drivers behind the rise are temporary in nature. For example, the disruption to supply chains that has also impacted the cost of transport will slowly reverse itself throughout 2022. Additionally, energy prices have been impacted by some seasonal factors as well as policy decisions on the renewable front. These may reverse themselves to some extent.
What does appear clear though is that we are entering an era when inflation is coming back to the table as an economic characteristic to contend with. As we shift from one environment to another, investment markets are likely to show higher levels of volatility than perhaps we have become accustomed to. Portfolio strategies should therefore be adjusted in anticipation of this and where regular saving is part of a retirement plan it may be wise to adjust these to also reflect higher inflation into the equation.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.