Inflation worries leading to increased volatility

Well over a year into the COVID-19 pandemic and the virus continues to have an impact on the world’s economies. Peter Forster, General Manager for BNZ’s Wealth business, looks at how inflation is driving financial markets and the impact it is having on some of our funds.

While most countries have been in a state of lockdown, or have faced some form of restrictions, both socially and economically, share markets have more than recovered from the initial sharp declines experienced in the first quarter of 2020. Economies and financial markets continue to be spurred on by historically low interest rates, unprecedented amounts of government stimulus and surprisingly fast vaccine development.

However, as the economic outlook improves and many economies reopen, investors will have to contend with the impacts of an unanticipated rise in inflation.

Why are businesses worried about inflation?

When goods and materials get more expensive, company revenues and profits can decrease because they struggle to immediately pass the additional costs on to their customers. And when costs are passed on those customers may choose to buy less.

High inflation usually also means higher interest rates, particularly in today’s environment where many of the world’s central banks have been tasked with creating an environment of sustainable rather than rampant growth. Higher interest rates help take the heat out of the economy by encouraging saving, rather than spending.

How have markets reacted?

Worries about inflation and the prospect of higher interest rates have spilled over into investment markets. Bond investments are more sensitive to interest rate movements so they have been more impacted than other asset classes. Bond prices (and therefore bond markets) tend to fall when investors expect interest rates to rise.

We also expect to see more ups and downs in share markets when inflation is rising. Dividend-paying companies and those geared to growth can underperform, while those with solid cash flows can do well. Technology companies have therefore been weaker this year, while blue-chip investments (well-established companies with a long track record) have fared better. This is also the reason why New Zealand shares have underperformed international shares. Our local market is known for having a large proportion of high dividend paying companies. These factors have seen different levels of performance across different markets – some have seen a pullback, others have pushed on to reach new record highs.

How has this affected the returns for our investors?

Most of our funds and investment strategies invest in a combination of shares and bonds; our conservative options have a higher weighting to bonds, while our more growth-orientated choices have a higher weighting to shares.

The recent falls in the value of bond markets has passed through to the performance of investments that have an exposure to bonds. Ordinarily, investors in our more conservative options might not be used to seeing the value of their investments both rising and falling. However, the weakness in bond markets means that these funds have been particularly impacted in recent times.

It’s not only our conservative options that have had a bumpy ride. More growth-orientated funds and strategies have also seen some volatile times, as share markets have also delivered mixed performances.

What’s next?

The recent jump in inflation expectations and its impact on investment performance is a timely reminder that there is risk associated with all investing – even if you invest more conservatively. While it’s hard seeing the value of your investments go down, you should also remember that most investment markets have had a strong run over the past 10 years and that ups and downs along the way should be expected.

Although markets and economies look forward to ongoing recovery, further volatility is expected in financial markets. However, ongoing low interest rates and ongoing government support continues to reassure businesses and markets – and we don’t expect that to change anytime soon.

As always, we encourage investors to consider their investment decisions in the context of how long they will be investing for, which for most will be several decades. Of course, being in a well-diversified investment, managed by a team of professionals that place a strong emphasis on quality, will also help.

Any views expressed in this article are the personal views of Peter Forster and do not necessarily represent the views of BNZ, or its related entities.

This article is solely for information purposes and is not intended to be financial advice. If you need help, please contact BNZ or your financial adviser. While BNZ has made every effort to ensure that the information provided is accurate, neither BNZ nor any person involved in this article accepts any liability for any loss or damage whatsoever which may directly or indirectly result from any advice, opinion, information, representation or omission, whether negligent or otherwise, contained in this article.