Inflation real(ly) weighs on returns

Given the barrage of headlines citing decades of high inflation, investors are asking how best to invest in an inflationary environment? In order to assess the current environment, it’s worth distinguishing nominal versus real rates using some examples close to home for everyone. Before you yawn and click off, here are a couple of interesting stats.

Over the 25 years pre-Covid19, average hourly earnings rose by 3.2%, while consumer prices eroded that by 1.9% on average each year. So, in real terms hourly earnings have grown at a compound rate of 1.2% (Dec 1994 – Dec 2019). Whilst it’s pretty hard to imagine or recall a floating mortgage interest rate of 10% and term deposits of 8% for many, that was the deal back in 1994. Add a labour force growing by ~1 million people (population grew by ~1.5m) at a rate of 1.7% per year to a long-term trend of falling mortgage rates and house prices have inflated by 6.3% each year on average. So in real terms house prices have gained 4.4% at a compounded rate.

During the last two bizarre pandemic years, wage growth has lifted to around 4% per year but inflation (4.6%) is consuming all of it and then some, meaning real wages have fallen 0.6% over 2020 and 2021. We have all seen how property prices have started rolling and if the RBNZ wants to achieve its ‘sustainable’ house price level, they’ve got further to go. Given mortgage rates are rising, people are feeling the pinch and the cries for the Government to allow talent to immigrate are falling on deaf ears.  Our view is the factors that drove house prices sharply up are in reverse for the time being, and the RBNZ sooner or later will prove successful in crimping economic growth and punching house prices lower.

Saving and investing for real returns

Whilst it’s likely a relief to many that term deposits have surged upwards from the QE induced <1% level recently into the 4% range. The challenge is that in real terms, savers are losing the buying power of their money given the June CPI print of 7.3%. In fact, after tax the term deposits net a saver around 2.5%, resulting in a real return of more than negative 4%. Fingers crossed inflation rolls over.

For those still looking for better yield with the possibility of capital growth, it’s worth highlighting that the listed real estate investment trusts (REITs) are paying a weighted average after tax yield of around 4%. Compare that to the weighted average after tax yield of around 3% from stocks in the NZ50. Whilst these yields are less than inflation there is at least some possible capital growth. The REITs are currently trading on large discounts to net tangible book value given expectations cap rates will expand. If the REIT managers believe their asset values are right and the market is wrong about the magnitude that cap rates will expand. The managers could divest a handful of assets to prove up value, even at a small discount to book and buy back stock whilst trimming gearing to boost shareholder returns.

More broadly, investing in equity funds with a long-term focus on growth compounders is the best way to generate positive real returns over the medium to long run. At the risk of stating the obvious these are the companies with sustainable returns on capital employed. Those that operate in rational markets with sound business models, strong management dedicated to operating their businesses well, and the ability to lift pricing in a tough environment and control costs are likely to continue to perform the best. These are the types of companies that can compound returns and grow their valuations over time as well as their dividends.

Sources:

• Factset
• RBNZ Prices (M1), Housing (M10), Labour Market (M9), Population and Migration (M12) found here Economic indicators - Reserve Bank of New Zealand - Te Pūtea Matua (rbnz.govt.nz)