Which asset classes are generally most resilient to rising inflation? Is it shares? property? bonds? infrastructure? If we put aside (for now) the possible unwinding of QE, then I have infrastructure and negatively geared property at the top of my list. There are many considerations in regard to inflation resilience, but here I emphasise two in particular. First, the importance of considering inflation’s affect on both the cash flows delivered by assets as well as the required return of investors. Second, the tax implications of inflation shifting the balance of total returns from income toward capital gains.
Are we headed into a period of higher inflation, beyond the 2-3% comfort zone of central banks? The signals are very mixed – the bond market says no, but history says yes. We don’t know which it will be, but it definitely matters. The outlook for inflation and interest rates is the biggest issue facing investors.
The first thing is to separate out two effects on asset prices from higher inflation:
- Quantitative Easing: The effect of tapering, ending and then unwinding QE (the new money created by QE going back into central banks); and
- The more normal effect of rising inflation on the cash flows from assets and the required return of investors.
What will happen if QE is tapered/ended/unwound, is a question for future articles. Here we want to park QE considerations and think about what rising inflation, just by itself, means for the prices of shares, property, bonds, infrastructure, etc.
A valuation of any financial asset ultimately depends on only two things:
- The asset’s expected cash flows each year in the future: Dividends from shares, net rent from property, interest from bonds, etc.
- The required return of the investor: The return on the risk free asset (treasury bond yields) plus extra return for risk plus extra return for illiquidity of the asset.
Required return = Risk free return + Risk premium + Asset liquidity premium.
Valuation is all about the quantity and quality of future cashflows, where investors need higher returns for investments with lower quality cash flows (longer term, riskier, more difficult to buy and sell).
In general, higher inflation affects both the quantity and the quality of cash flows and both need to be considered to see the overall effect. Inflation erodes the real value of the cash flows that the asset will deliver and investors need higher returns to compensate for that.
Unless the expected cash flows rise with inflation, investors will insist on paying a lower price for the asset to achieve their higher required return. Investors need either more cash in the future or a lower price upfront to compensate them for higher expected inflation.
Infrastructure is the physical assets of the economy that are shared in usage: Roads, electricity grids, mobile phone towers, airports, cloud computing centres, etc. Because infrastructure owners often have a natural monopoly, the prices that infrastructure owners can charge users are usually heavily regulated. It is also normal for regulators to increase the allowed prices directly with inflation.
Infrastructure is therefore largely immunized from inflation risk (that is an old expression having nothing to do with covid19). If higher inflation comes along, then the higher required return in each future year and higher cashflows will offset each other. It will be a wash as our American friends say. When inflation expectations change, that doesn’t affect infrastructure values today.
There is a danger of over-simplifying here in several ways. First, the rollout of QE pumped up infrastructure values and the unwinding of QE would have the opposite effect (we have parked QE for the purposes of this discussion). Second, required returns are driven by expected inflation and regulated prices are driven by actual, realised inflation, and the two may differ. Finally, the uncertainty surrounding rapidly rising inflation might increase the risk premium part of the required return.
Those factors need to be considered, but regardless, infrastructure comes in at the top of our list of asset classes least vulnerable to an increase in inflation.
For investors in negatively geared residential property inflation is bad in the short run, but good in the long run. Overall it is good.
In the long run inflation is a wash for residential property for the same reasons as infrastructure (but without infrastructure’s regulated cash flows). Inflation will increase the required return of both the providers of equity (you) and the providers of debt (the bank), but it will also increase rents over time. However, the bad comes before the good. The cost of higher interest rates is immediate, whereas the benefit of higher rents unfolds over the lifetime of the asset.
Consider an example. A rental property worth $1 million delivers rent, net of costs, of $17k. The property is financed with an $800k interest only mortgage with an interest rate of 2.5% for interest payments of $20k per annum. The annual loss on the property is $3k.
Inflation then jumps up by 2%. In response the bank raises the loan interest rate by 2%. The annual interest payment rises by 2% of $800k which is $16k extra, but the net annual rent only rises by 2% of $15k which is $300 extra. So, in the first year the loss jumps from $3k to $18.7k.
Then, as the years unfold, the rent rises at the higher inflation rate, but the interest payments remain the same. It is all good in the end, but the pain of increased interest payments is upfront, and the investor needs to survive that to get through to the compensating benefit of higher rents.
Essence of negative gearing
So, why then is inflation good (sometimes very good) for negatively geared property investors? Because negative gearing is a strategy of turning pre-tax income into capital gains which receive the 50% capital gains concession.
Another example will illustrate. Imagine that an investor makes losses on a negatively geared property of $20k per year for 10 years and after 10 years the property is sold for a capital gain of $200k. So $200k of pre-tax income generates $200k of capital gains. Obviously the investor would expect the capital gain toexceed the losses by a good amount, but let’s keep that part simple to focus on tax.
Without the negatively geared property the $200k of pre-tax income would have become $106k after-tax if the investor’s marginal tax rate is 47%. But with the property, the $200k of capital gain becomes $153k after-tax, because the 50% capital gains discount makes $100k of the capital gain exempt from income tax.
Therefore, on a before tax basis the $200k of income is forgone for $200k of capital gains. But on an after-tax basis, $104k is forgone for $153k. Negative gearing is a strategy of turning before tax income into capital gains. If you don’t understand that then you don’t know how it works.
Inflation generating capital gain
Negative gearing relies on capital gain to make it work, and the more the better. From a tax perspective, it doesn’t matter whether the capital gain is real or nominal (caused by inflation only).
The key here is that if inflation drives property prices up then the real (inflation adjusted), after-tax returns of negatively geared investors will be higher. The higher the leverage the higher the inflation benefits. The more inflation the better, so long as that inflation expresses itself in higher property prices.
Inflation and interest rates are just about perfectly aligned for Australian property investors at the moment. Interest rates can be locked in at record low levels for three years. Then, if at the end of the 3 years inflation has risen considerably, a highly leveraged negative gearing strategy will benefit from that. Alternatively, if inflation is low, the investor can rollover the low three year rate. So long as the investor can service the mortgage at higher interest rates (until rents rise), and so long as inflation makes its way into house prices, then it is a naturally hedged position.
Negative gearing and other investment strategies are fully explored and explained with examples and mini case studies in my investments course, Finance Education for Investors.