It’s not all bad news as markets retreat on inflation news
Despite the media hype surrounding last week’s US rate hike, interest rates are going up but not as fast or as damaging as everyone thinks. The RBA upped rates for the first time in over 11 years by 25bps to 0.35 percent from 0.10 percent. Roughly a $65 a month increase, on a twenty-five year $500k loan. The US Federal Reserve went a little harder with a 50bps rate hike to restrict inflation from rising past 7 percent. The RBA says its target rate-raising cycle sits between 2.5% and 3%, while the Federal Reserve’s target sits at 2.75% by Christmas.
Let’s say the average loan has a variable rate of 2.92%. Mortgage holders will be looking at a $98 for a $750k loan and $130 for a $1m loan. These are just rough indicators. Getting back to inflation… although the RBA hasn’t disclosed a formal inflation target, generally an acceptable inflation reading is around the 2.0-2.5 per cent mark. If inflation rises any higher, most fixed interest investments will be delivering negative rates of return.
The US / Australian rate rises were largely expected and weren’t a surprise. Nevertheless, inflation is high and needs to be contained to prevent a recession among other things. There are several factors that caused the price of goods and services to rise such as the massive monetary and fiscal stimulus injected into the economy, supply disruptions that are still slowing production and the global sanctions slapped on Russia preventing them from global trade.
Returns measured in real terms are adjusted for inflation. The problems start when the rate of inflation rises above the rate of return and begins to erode savings and purchasing power. For example, an investment that returns 2 per cent before inflation where investment returns 3 per cent. The end result? Inflation will produce a negative return (-1 per cent) when adjusted for inflation.
Despite all the negativity seen in the press, there is a flip side to this coin. Rising inflation does benefit certain sectors:
- Banks & Asset managers – In a rising inflation and interest rates environment, bank profitability is connected. When interest rates are raised, banks collect the difference between the interest charged on deposits minus the interest charged on borrowings. But there is a counter argument. By raising rates, mortgage defaults may start to rise, offsetting margin gains. This is a negative for banks.
- Healthcare – A rise in inflation is usually passed on to the client through higher excess or premiums. This makes a rise in inflation a positive for healthcare companies.
- Public infrastructure – Unlike other sectors, companies are able to pass on any added inflationary costs to the consumer without cannibalising sales. In the short term, infrastructure companies such as Transurban (ASX:TCL), benefit from higher interest rates.
- Energy, gas and oil – Rising energy supply and demand have a massive effect on the consumer price index, inflation rises especially in times of war. This is a positive for oil stocks.
- Gold – Is considered an inflation hedge and has been a safe haven for investors wanting to park their money to avoid inflationary pressures. Gold miners and the commodity are very different beasts.
- Insurance – In higher inflationary environments, insurance companies tend to increase premiums in line with inflation to fully offset inflationary pressures.
- Consumer staples – Coles (ASX:COL) and Woolworths (ASX:WOW) are in the consumer staples space and do well during inflation because demand for staples are inelastic and that gives these companies higher pricing power as they are able to increase their prices with inflation better than other industries.”