Katrina Robinson, Contributor
LAST YEAR inflation was 13 per cent and investors in the fixed-income market earned a negative real rate of return. This year it appears that inflation will be double digits once again. As the environment has experienced little change, it will still be difficult to prosper from relatively low risk, fixed interest rate investments.
The modern mantra is that inflation should be in single digits and preferably under 5 per cent. Given these low benchmarks our current inflation level is a cause for concern. Part of the reason inflation is so corrosive on investments is that if investors cannot earn a real rate of return, there is little incentive to save or invest and then the economy will not grow.
PERCENTAGE INCREASE
Inflation, measured as an annual percentage increase, is the rate at which the general level of prices for goods and services rise. Inflation greatly determines a currency's purchasing power which is the value of a currency based on what one unit of that currency can buy. As inflation increases, purchasing power decreases. When purchasing power falls, a greater amount of money is needed to maintain your usual standard of living.
A common indicator used to track inflation is the Consumer Price Index (CPI). This index reflects the price changes in a selection of consumer goods and services representative of the economy, such as housing, food and transportation.
Two widely accepted theories are often used to explain the root of inflation: demand-pull and cost-push inflation. When inflation arises from increased demand for goods available, demand-pull inflation dominates and this is often a sign of positive economic growth. Currently in Jamaica, however, our experience with inflation is weighted more towards the cost-push explanation which attributes the cause of inflation to an increase in the cost of goods.
Although today rising oil prices contribute the most to higher costs, in 2003 the rapid depreciation of the exchange rate was the main cause of inflation in Jamaica. In the last three years we have seen the largest tax increases. The increase in GCT compounded by the prolonged detrimental effects of Hurricane Ivan and recently Hurricane Dennis means that consumer goods will be heavily affected by inflation. The category of food and drinks alone accounts for 55 per cent of our CPI.
The effects that rising inflation may have on your financial situation however, are largely determined by your personal circumstances. Are you a creditor, or a debtor? A stock market or a fixed-income investor?
PAYING OFF LOANS
If you are paying off loans, you could benefit from inflation as while the dollar figure remains the same you are effectively paying less. On the other hand, the lender would be at a disadvantage as he will be receiving the same amount of funds, but with less purchasing power. Note that this only occurs if inflation exceeds the interest rate on the loan.
Fixed income investors are likely to be at a disadvantage in a high inflation environment than are stock market investors. Given a fixed interest rate of 13 per cent on a one year repo, and an inflation rate of 15.5 per cent, further compounded by a 25 per cent tax deduction, the real rate of return on the repo is a negative 5.75 per cent.
As an investor, you must pay attention to your real rate of return, meaning the growth of your purchasing power, as opposed to the nominal rate or the interest rate as it appears on your repo contract note. Although inflation is generally detrimental to investments, the effect is mitigated on shorter- term fixed income investments compared to long-term instruments.
If, however, you invest in the stock market, you have a better chance of combating inflation.
Companies increase their prices when production costs increase. Since the average company's revenues and earnings should move in line with inflation, as a stock holder your investment should move in pace with inflation. If, however, you invest in superior companies, your returns should outperform inflation. Using a buy and hold philosophy and purchasing stocks in outstanding companies will help you to realize real gains, that is, higher than the inflation rate.
If you think equities are too risky for you, there are other alternatives. You may want to hold some of your funds in hard currency and invest in global bonds. Many of these bonds provide investors with above average returns on US dollar or euro denominated fixed income investments and minimize taxes as they are mostly tax-free. To explore these and other options, get in touch with a Wealth Advisor who can help you hedge against inflation with an investment portfolio perfectly suited for you.
Katrina Robinson is a Wealth Advisor at NCB Capital Markets Limited and may be contacted a t1-888-4WEALTH or info@ncbcapitalmarkets.com
