Staying Ahead of Inflation Over the Long Run

Rising inflation not only reduces the purchasing power of investors’ hard-
earned money, it also has a significant impact on the real returns on their
investments.

Inflation is defined as a sustained rise in the general price level of goods and
services. Inflation increases the cost of living and reduces the real purchasing
power. It also erodes the value of investors’ savings and investments over time
if these instruments do not keep pace with the rate of inflation over the long
term.

Thus, it is essential that investors understand how the current trend in inflation
can affect the value of their investments and what can be done to stay ahead of
inflation over the long term.

Malaysia’s Rising Inflation Rate

In 2015 and 2016, Malaysia’s average inflation rate was fairly subdued at about
2.1% due mainly to the decline in fuel prices. However, the recovery in oil and
commodity prices since late 2016 has steadily pushed up the pace of domestic
inflation.

The domestic inflation rate surged to 4.2% in the first five months of 2017 from
an average of 2.1% in 2016 amid higher transportation costs. The weakness of
the Ringgit and the impact of the Goods and Services Tax (GST) have also
contributed to the rise in inflation.

For the full year of 2017, Bank Negara Malaysia has projected the inflation rate
to rise to between 3.0% and 4.0% (see Figure 1), which exceeds the 30-year
average of 2.6%.
 % Figure 1: Malaysia's Inflation Rate (2007-2017F)
6.0
5.4% Inflation spiked due to a surge in crude oil prices in 1H2008.
5.0
3.0%-4.0%
4.0 30-year average: 2.6%
3.2% 3.2%
3.0

2.0% 2.1% 2.1% 2.1%

2.0 1.7% 1.7%

1.0 0.6%

0.0
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017F

Inflation Rate 30-Year Average

Impact of Inflation on Investment Returns

Inflation is a concern for investors as it erodes the real value of investment

returns over the long term. The real rate of return can be estimated as the
nominal investment return minus the inflation rate.

Real Investment Return ≈ Nominal Investment Return – Inflation Rate

Assuming an investor makes a placement in a 12-month fixed deposit (FD) at a

rate of 3.1% at the beginning of the year. If the inflation rate for the full year is
4.3%, the investor will register an estimated real return of -1.2% over the period
as inflation has outpaced the nominal FD rate.

Real FD Return ≈ 3.1% – 4.3% = -1.2%

Given that the principal value of a FD remains unchanged while the FD rate is
fixed based on the tenure, rising inflation could erode both the principal and
interest income over the tenure of a FD. Thus, placements in FDs do not provide
adequate hedge against rising inflation.
Equities as a Hedge Against Inflation

The key to preserve one’s purchasing power is to hold investments that increase
in value at a rate that exceeds the inflation rate. Among the asset classes,
equities have proven to be a good hedge against inflation. Companies are
generally able to pass on higher costs of production to consumers by raising
their prices of goods and services over time. This allows companies’ revenues
and earnings to keep pace with the inflation rate. As a result, stock prices tend
to trend higher in an environment of rising prices of goods and services.

Over the last 30 years from 1987 to 2016, the domestic equity market, as
proxied by the FBM KLCI, generated an annualised nominal return of 6.4%
while the annualised nominal FD rate was 4.7% over the same period. After
adjusting for an average domestic inflation rate of 2.6%, the compounded real
rate of return from investing in the domestic equity market was 3.7% per annum
(p.a.), higher than the 30-year return of 2.0% p.a. from the FD placement.

Conclusion

Investors seeking to achieve higher real returns over the long term should
consider investing in equity unit trust funds that can potentially provide higher
returns than the prevailing inflation rate in the long run.

By periodically investing in equity unit trust funds, investors will be able to

cushion their investment portfolios against the impact of rising prices and
preserve the real purchasing power of their investments over time.

However, as the returns of equity funds can be volatile in the short term,
investors are advised to take a long-term view and maintain a diversified
portfolio of funds comprising domestic and foreign funds.