Adjusting to a new era of higher prices

THINGS have become more expensive. We call it inflation. But that also includes the cost of money - reflecting in interest rates - which has followed inflation higher.

Higher prices eat into the purchasing power of individuals, meaning that with the same money, we can buy fewer things. Higher interest rates are a tax on income as we pay more for mortgages and borrowings, and so have less money left over. Higher interest rates also lower the relative attractiveness of earnings at companies, and the coupon that bonds pay.

Singapore's headline inflation surged in March at the fastest pace in about a decade to 5.4 per cent from a year ago, as the cost of everything from food, housing, cars to services rose. Core inflation (that excludes accommodation and private transport) rose 2.9 per cent from a year ago.

Many are predicting a new era of higher-for-longer inflation, with the Covid-induced cost-push inflation exacerbated by the Russia-Ukraine war - the crisis compounded the price shock by pushing up oil, food, and metal prices. China's lockdown policy has added strain to supply-chain disruptions. We're in a perfect storm.

While inflation hurts our pockets, that's not the only impact to our finances that we should consider. Inflation has a clear impact on our real investment returns. An investment that returns 2 per cent before inflation in an environment of 3 per cent inflation would mean a negative return (-1 per cent) when adjusted for inflation. So far this year, we have also seen an unprecedented fall in both equities and bond prices, damaging our savings and wealth portfolios.

Who's afraid of big, bad, inflation?

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The latest Endowus Wealth Insights 2022 annual report found that the rising cost of living dominates as the top concern for most respondents. 45 per cent of those polled say inflation is their top finance-related worry for the year ahead; the fear of rising costs particularly stands out for those in the sandwiched generation.

Assuming an estimated annual inflation rate of 2.5 per cent, a sum of S$50,000 would only be able to purchase $30,514 worth of equivalent goods and services from 2022 in 20 years' time.

There is also a stark difference between just saving and investing. Deposits saved across 20 years on average bank deposit rates would lag inflation by about 35 per cent. That means S$50,000 saved in cash would become S$53,406 in deposits after 20 years, compared with the S$81,930 needed to beat the assumed 2.5 per cent inflation rate - a difference of over S$28,000.

If you had invested in financial markets and generated 5 per cent per year, then the same S$50,000 would be worth S$132,665. The way to safeguard against inflation isn't to hoard cash deposits that will certainly generate negative real returns, but to invest in financial markets to achieve higher returns. The Endowus Wealth Insights report found that 8 in 10 respondents plan to invest more in the year.

Look before you leap

With all that said, today's market volatility reflects the increasing anxiety over the high-wire act that central banks of major economies will have to walk to navigate this era of higher inflation - all without hurting global growth. It is a tough balancing act because the US Fed will have to lift interest rates that have been kept abnormally low as a result of both quantitative easing measures (i.e. printing money) that pumped cheap funding into the economy, as well as a strong fiscal response (i.e. writing cheques) to support businesses and households in response to the shock of the global pandemic.

That central banks failed to detect the stickiness of inflation does not bode well for the future trajectory of policy, which in turn will affect economic growth and market returns.

Meanwhile, there is now a whole generation of "meme stock" trading "hodling" investors who have never experienced a proper cycle or a bear market. Rising interest rates are always a bane of growth stocks trading at high valuations when rates were low. So as the unfolding crash of highly priced growth stocks has shown, markets today will punish complacency. 

Markets are brutal and largely efficient - they price in all known information as millions of investors and traders achieve price discovery. The Fed has only just raised policy interest rates by 0.5 per cent after a 0.25 per cent move in March, and Fed rates are approaching 1 per cent, but the bond market has already priced 10-year Treasuries at about 3 per cent, reflecting the expectations of the Fed's rate hikes for the rest of the year.

Therefore, what moves markets is the change at the margin from where we are today. At the moment, things will have to get a whole lot worse to price in an outcome that is worse than current expectations, as worries about both equities and fixed income markets remain high.

The volatile markets often should prompt investors to be more discriminate about the risks they are taking to get the returns they want from the markets. A shake-out and a cyclical downturn is not always such a bad thing. For long-term investors, it's another opportunity to pick up valuable assets and companies at a cheaper, more reasonable price. 

We know we cannot control the outcome of wars or pandemics, or predict the peak of inflation or interest rates. What we can control is our own behaviour or emotions - not to panic and sell at the bottom, or to chase overvalued growth stocks at the top.

We can also control the cost of investing. A recent Morningstar report showed that Singapore ranked below average out of 26 markets in terms of fees and expenses for funds.