When Inflation Changes the Investment Equation

FY26 began with expectations that inflation would keep easing and interest rates would move lower. Instead, inflation proved more persistent, economic activity was stronger than expected and global energy disruptions added further pressure. Markets moved quickly from expecting rate cuts to again considering the possibility of higher rates.

Forecasts can be useful, but they are not a plan. A well-constructed portfolio should not depend on any single forecast being right.

For investors who rely on their portfolios for income, both the amount of income received and its purchasing power matter. Higher housing, energy, food and service costs can reduce what that income can buy, especially over a retirement that may last 20 years or more.

A wider range of possible outcomes

Current conditions, in our view, are not a repeat of the global financial crisis or the early stages of COVID-19. This is a different kind of environment. Inflation, central bank decisions, energy prices and geopolitical events are changing expectations quickly, and those changes are flowing through to markets, asset prices and borrowing costs.

The global outlook changed materially during FY26. In January, the International Monetary Fund expected inflation to decline from 4.1 per cent in 2025 to 3.8 per cent in 2026. By April, conflict and commodity pressures had led it to expect a modest rise during 2026 before inflation resumed declining in 2027.

Portfolio resilience should not depend on one view of inflation, growth or interest rates. Investors should consider how their holdings may behave if inflation falls slowly, stays higher for longer or rises again, and how they may respond if growth slows or markets reprice sharply.

When shares and bonds move together

For much of the first two decades of this century, shares and high-quality government bonds often moved in opposite directions. When growth expectations weakened, shares could fall while bonds helped cushion portfolios. That relationship has been useful, but it is not guaranteed.

Bank for International Settlements research found that the correlation between US equities and government bonds turned positive in mid-2021 after being predominantly negative for two decades, with elevated and uncertain inflation identified as a central cause. An unfavourable inflation surprise can reduce the real value of fixed bond payments, keep interest rates higher and pressure equities through increased financing costs and lower valuations.

Shares and bonds remain important portfolio building blocks, but there will be periods when they move in the same direction. Investors may therefore benefit from drawing income and returns from a broader range of sources rather than relying on bonds to cushion every period of sharemarket weakness.

Headline returns can conceal very different experiences

The S&P/ASX 200 increased by 2.8 per cent in price terms and delivered a total net return of 5.9 per cent, including dividends, during FY26. Beneath that headline result, sector performance varied considerably. Materials gained approximately 48 per cent, while the Healthcare and Information Technology sectors each declined by around 37 per cent.

This matters because investors do not experience markets through index numbers alone. Capital values and income can vary depending on what they own, which sectors they are exposed to and how dividends change over time.

Broadening the sources of portfolio income

Investors should look beyond labels. What matters is how an investment earns income, the quality of the underlying assets, the risks involved and the discipline applied by the manager.

Broadening the sources of portfolio income can reduce reliance on any single market or asset class, provided each investment is selected carefully and has a clear role within the portfolio.

Investors should focus on asset quality, genuine diversification, disciplined liquidity management, transparency and a manager’s experience across market cycles. They should also understand how income is generated, when capital can be accessed and how the investment fits their objectives, risk tolerance and broader portfolio.

Discipline through changing conditions

At La Trobe Financial, we continue to see demand from creditworthy borrowers and from investors seeking income-producing assets. Our role is to bring those needs together carefully, without compromising the disciplines designed to protect investor capital.

Before capital is deployed, we assess the borrower, the security, the loan structure and the borrower’s capacity to service and repay the debt. We also consider how the investment may perform if rates remain higher, economic activity weakens or asset values fall.

Margin of safety is built through diversification, documentation, monitoring, stress testing and disciplined liquidity management.  It does not remove risk, but it gives the portfolio a stronger starting point when conditions change.

Many assets within our portfolios are designed to respond to changes in interest rates, which means the income they generate can adjust as rates change. This does not remove inflation risk or guarantee that income will exceed inflation, but it is one way portfolios can be built with changing conditions in mind.

FY26 reinforced the value of sticking to fundamentals. Markets will keep changing, and forecasts will keep moving. Our role is to assess each opportunity on its merits and apply the credit disciplines developed over decades, conscious that investor capital may need to support many years of retirement.