Higher living costs affect everyone, but retirees may feel the greatest impact in two main ways:

• Retirees typically rely on a fixed income or a pension. As inflation rises, the purchasing power of that dollar amount is eroded. 
• Unlike younger investors, retirees often have shorter investment horizons or are already in the drawdown phase of investing. This means they often have greater liquidity requirements, but do not have the risk tolerance for the higher risk investment mix required to generate sufficient returns to offset the impact of inflation.
  

For most retirees, capital preservation and income are the primary considerations. Term deposits may thus provide an appropriate investment alternative. 

However, it is important to recognise that term deposit rates have not kept pace with inflation, so in real terms (after inflation), deposit rates effectively offer negative real returns, because the current inflation rate exceeds the rate of return on cash.  As a result, the purchasing power of those invested funds is eroded.  
 

Where do retirees invest during high inflation? 

In the past year, bond markets have experienced some of the largest drawdowns in history, making it a challenging environment for fixed-income investors. This is because bond prices and yields move in opposite directions, so as bond yields have surged to reflect higher inflation expectations, bond prices have fallen. 

Most bonds in Australia are fixed rate and because the coupon is fixed, it is the bond price that is forced to adjust down to attract investors. Variable-rate bonds are generally preferred in a rising rate environment because the coupon is typically adjusted each quarter and captures higher interest rates, according to Ord Minnett. 

The good news is that historically, most of the damage to bond prices is done before the first rate rise. With the first rate rise complete and the 10-year bond yield in Australia above 3.0% (in May 2022) Ord Minnett believes Australian bonds are looking more attractive and we have begun increasing our allocation to bonds for our clients.  

Hybrid securities are an example of the variable-rate securities we include in client portfolios. The distributions are calculated by adding a fixed margin to a benchmark interest rate, so as rates rise, investors should receive more income. 

For retirees, hybrids can potentially tick several boxes including: a regular income stream, higher returns than other fixed income products, and a meaningful component of the return is from franking credits. 

[Editor’s note: Generally, hybrid securities pay higher returns than bonds because there is usually a higher level of risk attached to a hybrid security than to a bond. Special care should be taken when assessing the risk of hybrid securities due to the blend of equity and debt characteristics, as the price may behave quite differently in different market scenarios. Hybrid securities are generally complex in nature with potentially higher risks than other forms of investment. Investors should obtain independent advice before making any investment decisions.]

It is worth noting that because hybrids contain equity-like features, they can be more volatile than other fixed interest assets, although our analysis has revealed they exhibit diversification benefits when blended with a portfolio of Australian bonds and equities. 

Equities have proven to be effective inflation hedges over the long term, as the returns typically outpace the rate of inflation. Our market is particularly interesting for those seeking inflation protection, as it is dominated by commodity-linked businesses and banks – the two main sectors that benefit from higher interest rates. 

It is also worth looking for companies with pricing power in their respective industry and the ability to pass on higher costs to customers.  

Ord Minnett believes that blending a combination of cash, fixed income and equities is critical to safeguarding portfolios from inflation, but also balancing other investment objectives of retirees such as capital preservation and income. 

Earnings growth is the primary driver of long-term capital appreciation, so a company’s ability to maintain profit margins and continue compounding profit growth is one of the most important factors to evaluate when investing with a growth objective in this current environment. 

Regardless of the type of asset, there are three key factors to consider with respect to inflation and the interest rate sensitivity of a company’s earnings:

1. The extent of inflation linkage in revenues
2. Ability to manage costs
3. Capital structure and financing

Pricing power is crucial

Inflation can be both a blessing and a curse for a company’s profit margins. 

It may help a company’s growth by increasing cash flow. Many companies, especially those that are commodity-related, can pass through higher costs via pricing power, potentially leading to higher margins. However, these same inflationary pressures can potentially increase input costs.

When evaluating a company’s ability to raise prices above inflation and preserve profit, one could consider three things: whether the good or service that it sells has alternatives; whether the company is a price maker or price taker in its industry; and how critical this product or service is to other businesses or consumers. Companies operating in regulated sectors (such as utilities) or that produce daily necessities (consumer staples) and critical commodities (such as energy) are some examples.  

When assessing a company’s effectiveness in maintaining costs, one could consider how easily a company can find alternatives to their key inputs and how reliant they are on debt financing to continue growing. Companies that can source primary components from various sources and operate with fewer fixed inputs are more likely to succeed in maintaining costs. Companies that are less sensitive to higher interest rates are better able to preserve profit margins.
 

What does higher inflation and interest rates mean for stock valuations?

Ord Minnett has looked at how higher inflation and interest rates can impact cash flow and profit margins. Let’s now assess how valuation (the other key long-term driver of capital growth) performs in these same economic conditions. 

If inflation leads to higher interest rates (as we are starting to see across many developed economies), it increases the discount rate used to gauge the present value of future cash flows. Higher discount rates cause the market to devalue assets with future cash flows, and the further out they are, the more detrimental the impact. 

This is likely to have a more pronounced impact on growth stocks for two reasons (among others):

1. A significant proportion of the valuation is comprised of potential future earnings and these companies typically trade on higher earnings multiples to account for this long-term growth; and
   
2. As many of these companies are reliant on raising external capital to fund their growth, higher interest rates make this more expensive and can make reinvesting for growth more challenging.  

Ord Minnett believes that value stocks can potentially provide more of a buffer from an inflationary and rising interest rate environment. Current earnings make up a higher proportion of their total valuation and they are less susceptible to the devaluation caused by applying higher discount rates to longer-term cash flows.

As higher inflation and interest rates become more entrenched in asset markets, a company’s pricing power and ability to manage funding costs should become a key element that gets factored into one's investment decision-making process.