Central banks around the world have been pulling levers to combat the economic impacts of Covid-19.

The Reserve Bank of New Zealand did this, too, utilising quantitative easing and reducing the Official Cash Rate (OCR) to a record low. This led to lower interest rates, which encouraged people to spend.

While consumer spending is important, when the supply of money entering the economy begins to outpace economic growth, we experience increasing inflation.

Some inflation is good

Moderate inflation is generally viewed as a positive for our economy. As prices rise, we’ll spend now, to avoid paying more later.

As demand for goods and services goes up, we need more supply to meet demand and firms hire workers to boost production.

Everyone benefits, the economy grows, demand increases, wages improve and the cycle goes on.

The Reserve Bank is tasked with keeping inflation between 1 and 3 per cent.

Each quarter, Statistics New Zealand tracks the prices of thousands of items we buy, in the Consumer Price Index (CPI).

Since 2000, the index has tracked inflation at an average of around 2.15 per cent a year. But on 18 October, the Reserve Bank said inflation was at 4.9 per cent.

This has many investors questioning the structure of their investment portfolios.

High inflation can be damaging.

It erodes your purchasing power. You may be left worse off if prices rise faster than your income.

Inflation can undermine the ‘real value’ of an investment if the returns aren’t enough to cover the level of inflation.

Boom and bust cycles. Inflationary periods can be a sign of an overheated economy, leading to it expanding, then contracting, over and over again¹.

With inflation at 4.9 per cent, investors are losing $49 of purchasing power for every $1000 in the bank.

Many term deposit rates sit around 1 to 2 per cent², which won’t offset inflation, especially once tax from returns are deducted.

Since we first saw Covid-19 in 2020, the OCR has been cut numerous times, dropping to a record low 0.25 per cent before most recently pushing up to 0.5 per cent.

This has kept interest rates across conservative asset classes like cash and bonds very low.

Investors in these conservative asset classes have only been treading water since 12-month term deposit rates dipped below 3 per cent in August 2019.

Now that inflationary pressures are growing, investors are right to be worried about what their money will soon be worth; and they are asking what asset classes typically perform well through inflationary periods.

Look to physical assets

Investing in physical assets such as directly owned property, precious metals like gold, and real asset shares have historically been reliable options to protect against inflation.

These asset classes move in lockstep with inflation and in the past have benefited because capital values are going up at a rate at least equal to, or better than inflation.

Directly held real estate generally delivers capital growth over time, while generating reliable cash returns from tenants.

However, commercial real estate typically offers longer lease terms and better tenant stability, compared with residential property.

With construction costs continuing to increase on the back of supply constraints and increasing inflation, valuations of existing buildings increase too.

Commercial leases often include clauses that tie rent reviews to inflation. This helps offset the affects of inflation on rental income and can help preserve yields.

This is evident when the average residential property yield in Auckland is 2.8%³ compared to returns of 5.5-6% from PMG’s funds⁴.

Delivering returns above inflation

With inflationary pressures rising, the New Zealand commercial property sector is well positioned to continue delivering returns that can offset inflation.

Equity markets continue to experience greater volatility, and we are noticing that experienced investors and fund managers continue to gravitate towards investments in real assets such as commercial real estate.

Traditional portfolio allocations with conservative assets in bonds and fixed interest are not currently delivering returns that can overcome inflation.

If you’re concerned about that, consider directly held New Zealand commercial property as part of a diversified investment portfolio.

Information is correct as of 1/11/2021 and contains the opinions of Ben Cant and Rory Diver, and general commentary and views from PMG. Any information provided in this article is for information purposes only, is not intended to be relied upon, and should not be construed as financial advice. Prospective investors are recommended to seek professional advice from a Financial Advice Provider who takes into account their personal circumstances.

Sources: ¹https://www.rbnz.govt.nz/-/med...;

²https://www.interest.co.nz/sav...

³https://www.blog.reinz.co.nz/r...

⁴Returns are based on historical performance of the funds managed by PMG, as at 31 August 2021. Past performance is not a guarantee of future performance. Please refer to pmgfunds.co.nz for current metrics and more information.

www.pmgfunds.co.nz