The end of the year is always a good time to reflect on financial decisions and lessons learned. While it’s not our intent to dredge up bad memories, you may recall the multitude of headlines from 2021 and 2022 that sparked significant concerns about inflation and its impact:

"Inflation hits highest level in a decade"¹

"Cost of living crisis: Inflation surges to 5.9%"²

"NZ inflation hits 30-year high at 6.9%"³

"Soaring inflation: What it means for your wallet"⁴

These headlines understandably fuelled anxiety among investors with many wondering what does this mean for my portfolio?

The impact of inflation and rising interest rates

In response to inflation pressures, the Reserve Bank of New Zealand (RBNZ) quickly raised interest rates from the historic lows seen during the post-COVID period. This move had a notable impact on term deposit (TD) rates, which climbed to 5-7%, making them suddenly more attractive than they had been for over a decade.

New Zealanders responded by shifting significant amounts of their money into TDs. Data from the RBNZ (see chart below) shows that investors moved strongly back into TDs from early 2022, commencing a trend which continues today.

¹ Source: The New Zealand Herald, Date: October 19, 2021
² Source: Stuff.co.nz, Date: January 27, 2022
³ Source: RNZ (Radio New Zealand), Date: April 21, 2022
⁴ Source: Otago Daily Times, Date: April 22, 2022
⁵ Source: The Dominion Post, Date: May 1, 2022

With New Zealand interest rates on the rise at the time, this behaviour wasn’t unexpected - higher interest rates often draw investors into fixed-term, 'safer' investments like TDs. By early 2023, average 2-year TD rates had risen to 5.35%⁶, up sharply from around 2.7% in early 2022. For many investors, this seemed like a safe and logical move amid volatile markets.

Unfortunately, while inflation helped push interest rates and TD rates higher, it didn’t necessarily mean that TDs became a more attractive investment option.

⁶ Source: www.interest.co.nz

 The reality of TDs as inflation hedges

While TDs offered predictability and stability, they weren’t (and aren’t) the best tool to counter inflation. The chart below shows how several different investments compared over the period from January 2023 to November 2024.

The key insight is that 2-year TDs just barely outpaced inflation before tax, but they underperformed bond funds and significantly underperformed other investment options like balanced portfolios, and aggressive equity-focused portfolios.

Source: Consilium calculations; inflation data from RBNZ Inflation Calculator. Due to data unavailability, inflation above is from Q4 2022 to Q3 2024.

In fact, if investors were rolling over TDs with shorter durations (like 6 months), then average TD rates were even lower than those highlighted in the chart above. For many investors in 6 month TDs over this period, their real return (i.e. after tax and inflation) would actually have been negative, particularly investors on higher marginal tax rates.

Why investors chose term deposits

Many investors turned to TDs in early 2023 because of:

• Market losses in 2022: Portfolios and bond funds suffered losses during 2022. Looking at prior annual returns early in 2023 meant facing red ink across nearly every asset class.
• Emotional decisions: With inflation dominating headlines and purchasing power eroding, TD rates above 5% seemed like a logical and enticing safe haven.
• Fear of volatility: Comparing recent losses in equity portfolios to 'guaranteed' returns from TDs made the latter seem like a no-brainer.

Looking back: lessons from 2023 and beyond

Two years later, the results are clear:

• Aggressive portfolios (98/2) returned over 18% per year on average.
• Inflation averaged just under 4% over the past 8 quarters as recorded on the RBNZ website eroding purchasing power but not dramatically.
• 2-year TDs returned a little over 5%, offering stability but failing to meaningfully grow wealth.

Could anyone have predicted these outcomes with certainty? No. But one thing remains clear - TDs are not the right tool to grow wealth or effectively counter inflation over the long term.

Why long-term investing works

Inflation increases the cost of goods and services, but businesses adapt. As prices rise, businesses typically see higher nominal earnings, which, over time, translate into higher equity valuations. This relationship isn’t linear or immediate, but over the long term, it holds true – and it held true during this period as well. It means that when inflation pushes up prices and, effectively, company valuations, a diversified exposure to company shares can be a very effective long term inflation hedge.

Investors who stayed the course and maintained diversified portfolios reaped the benefits of share growth and market recovery, far outpacing the returns from term deposits.

Key takeaways for investors

1. Invest for the long term: Avoid knee-jerk reactions to market volatility or media headlines.
2. Tune out the noise: Recent market performance and sensational headlines rarely offer the full picture.
3. Avoid short-term comparisons: Don’t let attractive TD rates or recent losses dictate your financial strategy.
4. Stay disciplined: A diversified portfolio tailored to your goals and risk tolerance remains your best tool for growing wealth.
5. Relax and enjoy the summer: A long term plan doesn’t need your constant daily attention, so unplug and enjoy life while your money (and your adviser) works.