Inflation genie out of the bottle

Despite favourable trading conditions, the rate is rising - and don't hold your breath waiting for it to be squeezed back.

By InvestSMART · 31 Jul 2011

By InvestSMART ·
31 Jul 2011

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Despite favourable trading conditions, the rate is rising and don't hold your breath waiting for it to be squeezed back.

WOULDN'T you know, everything is going up except share prices.

Inflation is rising everywhere, most ominously in China, so there's no way we were going to be spared.

But the worry in the annualised, underlying rate creeping outside the Reserve Bank's comfort zone is that it was despite a retail recession and a strong dollar bearing down on import prices.

That's not good - the inflation genie is out of the bottle. And don't fall for the three wishes trick, either.

Unless the Reserve Bank is willing to lift interest rates three or four times in rapid, confidence-sapping succession, which I doubt, the only hope of squeezing it back would be an even higher dollar.

That would require the US dollar to sink even further and China to keep growing at the same elevated rate forever.

There are too many vested interests - think every other country that doesn't want its own currency going too high - to allow the US dollar to drop much more.

Thankfully, where it's been hanging around has done wonders for Wall Street, which, all things considered, has been remarkably sanguine about the world's sovereign debt issues, especially its own.

After all, the Dow is dominated by multinationals that are raking it in, thanks to the weak US dollar.

The profit surge on Wall Street, the global bellwether, makes our sharemarket safer than it looks, if you go about it sensibly.

As inflation rises, savings accounts, term deposits or bonds become riskier. Notice how their interest rates have been stable or falling while inflation has been rising.

But the returns on dividends have been going up - not that you would have noticed, what with having to keep up with the latest debt crisis and all.

The average yield from the biggest 200 stocks is almost 6 per cent, after taking the 30 per cent tax credit from franking into account.

Sure, you can also get that on an online bank deposit but not after tax. And it's a waste of time staying cashed-up waiting for a sensational term-deposit rate to come along. That won't happen when nobody is borrowing, so the banks don't need to raise more money.

Still, at least you know you'll get your money back with a bank deposit. Well, yes and no. After tax and inflation, there won't be much left.

A blue-chip stock will grow, though it doesn't pay to be picky about exactly when.

Amazingly, the best-paying stocks have done worse than the overall market despite, in most cases, increasing their dividends.

Telstra, I hate to say, comes to mind.

The fact is it has a dividend to die for - and its shareholders have waited so long for the price to recover, some might have died.

Yet, at $3, the yield on Telstra shares is 9.3 per cent from its 28? dividend, which is not under any threat. With franking, it jumps to 13 per cent. Even if the share price dropped 10 per cent, or 30? - we're talking Telstra, so best to be realistic - you'd still be ahead of a term deposit.

The banks are better still. They've been marked down so far it's more likely their share price will rise than fall over, say, the next year.

And while you're waiting, they're yielding almost 10 per cent after franking credits.

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Frequently Asked Questions about this Article…

What does the article mean when it says the “inflation genie is out of the bottle” and how should investors react?

The article means underlying inflation is creeping above the Reserve Bank’s comfort zone and looks entrenched, not easily reversed by a single policy move. For everyday investors that implies cash and fixed-rate returns are at risk in real terms; consider reviewing portfolios for inflation protection (for example dividend-paying shares or other assets that can outpace inflation) rather than simply waiting in cash for better term-deposit rates.

Are savings accounts, term deposits and bonds still safe choices while inflation is rising?

They remain secure in nominal terms, but the article warns they’re becoming riskier in real terms because interest rates on savings and term deposits have been stable or falling while inflation rises. After tax and inflation, the actual purchasing power from those products may be minimal, so investors should weigh real return (after tax and inflation) when choosing these options.

How do dividend-paying shares compare to bank deposits as a hedge against inflation?

The article notes dividend returns have been increasing and can offer superior after-tax income to deposit rates. For example, the average yield from the largest 200 stocks is almost 6% after including a 30% franking tax credit. While some online deposits might match gross yields, they typically don’t beat dividends after tax and franking credits — though shares carry different risks than bank deposits.

What are franking credits and how do they improve dividend returns for Australian investors?

Franking credits are tax credits attached to dividends that reflect company tax already paid. The article cites a 30% franking tax credit example: when you include franking credits, dividend yields can rise significantly (the big 200 stocks average nearly 6% after franking). Franking can make dividend income more tax-efficient compared with interest from deposits.

Is Telstra a good example of a high-yield stock during rising inflation?

The article uses Telstra as an example of a high-yield stock. At a $3 share price it reports a yield around 9.3% and roughly 13% including franking credits, and notes that the dividend is not seen as under threat. The piece suggests that even with some share-price volatility, such dividend income can outperform a term deposit in real terms — though individual investor circumstances and risk tolerance vary.

What does the article say about bank shares as an income option for investors?

The article points out bank shares have been marked down and are now yielding strongly — almost 10% after franking credits — and suggests their share prices are more likely to rise than fall over the next year. It positions bank stocks as potentially attractive income investments, while reminding readers to consider the different risk profile compared with holding cash.

How does the weak US dollar and Wall Street profit surge affect Australian investors?

According to the article, a weak US dollar has helped multinational companies on Wall Street produce strong profits. That global profit surge acts as a positive signal for equity markets and can make the Australian share market look safer than it might otherwise, particularly for investors who focus on multinational exposure and sensible portfolio construction.

Will the Reserve Bank quickly lift interest rates to squeeze inflation back?

The article is skeptical that the Reserve Bank will lift rates three or four times in rapid succession to crush inflation, calling such a campaign unlikely. It also notes the only other realistic way to reduce imported inflation would be a substantially higher local currency, which faces international and political obstacles. The bottom line: rapid big-rate hikes are not presented as the most probable path to lower inflation.