Jarden Wealth Weekly: Investing in a high-interest rate environment

The relationship between inflation and financial assets is not always straightforward. Photo / 123RF

OPINION

In line with Jarden expectations, but despite some economist’s predictions, the New Zealand official cash rate (OCR) held steady at 5.5 per cent last week.

Over the last couple of years, investors who have invested in cash accounts or term deposits have benefited as central banks globally were forced to push up interest rates from the 2021 lows to combat high inflation.

This year we’re seeing mixed views from economists as to whether New Zealand is at the peak of the current interest rate cycle. Inflation in NZ continues to fall which raises the question: Has the Reserve Bank of New Zealand (RBNZ) done enough to curb inflation?

The RBNZ aims to hold inflation between 1 to 3 per cent, with a preference for 2 per cent or lower.

According to Statistics NZ, as of December 31, 2023, NZ inflation was at 4.7 per cent for the year, down from an annual rate of 5.9 per cent the previous quarter.

This inflation figure is made up of two components:

• Tradable inflation, which refers to the price changes in goods and services that are imported or in competition with foreign goods. This has subsided considerably over the past twelve months to 3.0 per cent, down from the previous quarter of 4.7 per cent.
• Non-tradable inflation which refers to the price changes in goods and services within New Zealand. While it has fallen slightly, this remains elevated at 5.9 per cent, down from 6.3 per cent in the previous quarter.

Inflation data, alongside recent lower-than-preferred unemployment numbers (at 4.0 per cent), provides an interesting backdrop to the question of where New Zealand’s interest rates may go for the remainder of 2024 and beyond.

Internationally, inflation has cooled considerably faster in other developed economies. While these economies are being cautious about timing interest rate cuts, it’s likely interest rate cuts may occur sooner offshore than in New Zealand.

The impact of inflation on investors

Higher inflation typically results in increasing interest rates, which can make cash, term deposits and bonds look more attractive due to the higher rates on offer.

Market interest rate movements do not have a direct impact on the valuation of cash and term deposit holdings, which are not typically repriced. However, they do impact bond holdings (which are tradable on the secondary market, so are regularly repriced in response to current market interest rates).

So, while higher interest rates can be attractive for new investors, they can negatively impact existing bond holders.

Generally, if interest rates have moved up since the issuance of the bond, the price of the bond will have declined. Conversely, if interest rates have moved down since the bond was issued, the valuation of the bond will be higher.

Higher inflation also erodes the purchasing power of future interest and principal payments. Those with fixed-rate investments may find the real value of their returns (i.e. the actual return after inflation) decreases in an inflationary environment.

In addition, higher inflation can have a negative impact on equities as companies face higher input costs and squeezed profit margins. Higher interest rates can also make bonds look more attractive relative to equities, leading investors to shift their portfolios towards bonds and potentially putting downward pressure on equity prices.

Interest rates are not the only factor that moves bond prices - the outlook on the individual company issuing the bonds will also have an impact, and if the company looks unlikely to meet its obligations, the price of the bond may fall despite any downward movement in market interest rates.

If interest rates move lower in the next few years, how best do you protect yourself from interest rate risk?

At some point in the future inflation will be back within the RBNZ’s target ranges, likely prompting interest rates to be cut. With interest rates expected to move lower, both bonds and equities can benefit.

Bonds become a more attractive proposition for existing bond-holders as the reduction in interest rates will likely drive bond process higher.

If interest rates are expected to fall, it may be a good opportunity to lock in the current higher rates for the longer term, as these longer-duration bonds will experience more significant price appreciation in a declining interest rate environment.

While we continue to expect the RBNZ will be in a position to cut the OCR in the near future, for now we remain in a high-inflation - and subsequently high-interest rate - environment.

Furthermore, the relationship between inflation and financial assets is not always straightforward, as there are numerous other factors influencing equity and bond prices.

For this reason, investors are encouraged to hold a diversified portfolio of assets to manage the risks associated with inflation, interest rates and industry of company specific issues.

Matthew Hands is a wealth management adviser at Jarden.

Jarden Securities Ltd is an NZX firm. A financial advice disclosure statement is available free of charge at https://www.jarden.co.nz/our-services/wealth-management/financial-advice-provider-disclosure-statement/.

Full disclaimer available at: https://www.jarden.co.nz/wealth-sales-and-research-disclaimer