Most individuals are aware that inflation raises the cost of their food and depreciates the worth of their money. In reality, inflation impacts every aspect of the economy, and it can eat into your investment returns over time.
What is inflation?
Inflation is the gradual increase in the average cost of goods and services. The Bureau of Labor Statistics, which compiles data to construct the Consumer Price Index, measures it (CPI). The CPI measures the general rise in the price of consumer goods and services by tracking the cost of products such as fuel, food, clothing, and automobiles over time.
The cost of living, as measured by the CPI, increased by 7% in 2021.
1 This translates to a 7% year-over-year increase in prices. This means that a car that costs $20,000 in 2020 will cost $21,400 in 2021.
Inflation is heavily influenced by supply and demand. When demand for a good or service increases, and supply for that same good or service decreases, prices tend to rise. Many factors influence supply and demand on a national and worldwide level, including the cost of commodities and labor, income and goods taxes, and loan availability.
According to Rob Haworth, investment strategy director at U.S. Bank, “we’re currently seeing challenges in the supply chain of various items as a result of pandemic-related economic shutdowns.” This has resulted in pricing imbalances and increased prices. For example, due to a lack of microchips, the supply of new cars has decreased dramatically during the last year. As a result, demand for old cars is increasing. Both new and used car prices have risen as a result of these reasons.
Read a more in-depth study of the present economic environment’s impact on inflation from U.S. Bank investment strategists.
Indicators of rising inflation
There are three factors that can cause inflation, which is commonly referred to as reflation.
- Monetary policies of the Federal Reserve (Fed), including interest rates. The Fed has pledged to maintain interest rates low for the time being. This may encourage low-cost borrowing, resulting in increased economic activity and demand for goods and services.
- Oil prices, in particular, have been rising. Oil demand is intimately linked to economic activity because it is required for the production and transportation of goods. Oil prices have climbed in recent months, owing to increased economic activity and demand, as well as tighter supply. Future oil price rises are anticipated to be moderated as producer supply recovers to meet expanding demand.
- Reduced reliance on imported goods and services is known as regionalization. The pursuit of the lowest-cost manufacturer has been the driving force behind the outsourcing of manufacturing during the last decade. As companies return to the United States, the cost of manufacturing, including commodities and labor, is expected to rise, resulting in inflation.
Future results will be influenced by the economic recovery and rising inflation across asset classes. Investors should think about how it might affect their investment strategies, says Haworth.
How can inflation affect investments?
When inflation rises, assets with fixed, long-term cash flows perform poorly because the purchasing value of those future cash payments decreases over time. Commodities and assets with changeable cash flows, such as property rental income, on the other hand, tend to fare better as inflation rises.
Even if you put your money in a savings account with a low interest rate, inflation can eat away at your savings.
In theory, your earnings should stay up with inflation while you’re working. Inflation reduces your purchasing power when you’re living off your savings, such as in retirement. In order to ensure that you have enough assets to endure throughout your retirement years, you must consider inflation into your retirement funds.
Fixed income instruments, such as bonds, treasuries, and CDs, are typically purchased by investors who want a steady stream of income in the form of interest payments. However, because most fixed income assets have the same interest rate until maturity, the buying power of interest payments decreases as inflation rises. As a result, as inflation rises, bond prices tend to fall.
The fact that most bonds pay fixed interest, or coupon payments, is one explanation. Inflation reduces the present value of a bond’s future fixed cash payments by eroding the buying power of its future (fixed) coupon income. Accelerating inflation is considerably more damaging to longer-term bonds, due to the cumulative effect of decreasing buying power for future cash flows.
Riskier high yield bonds often produce greater earnings, and hence have a larger buffer than their investment grade equivalents when inflation rises, says Haworth.
Stocks have outperformed inflation over the previous 30 years, according to a study conducted by the US Bank Asset Management Group.
2 Revenues and earnings should, in theory, increase at the same rate as inflation. This means your stock’s price should rise in lockstep with consumer and producer goods prices.
In the past 30 years, when inflation has accelerated, U.S. stocks have tended to climb in price, though the association has not been very strong.
Larger corporations have a stronger association with inflation than mid-sized corporations, while mid-sized corporations have a stronger relationship with inflation than smaller corporations. When inflation rose, foreign stocks in developed nations tended to fall in value, while developing market stocks had an even larger negative link.
In somewhat rising inflation conditions, larger U.S. corporate equities may bring some benefit, says Haworth. However, in more robust inflation settings, they are not the most successful investment tool.
According to a study conducted by the US Bank Asset Management Group, real assets such as commodities and real estate have a positive link with inflation.
Commodities have shown to be a dependable approach to hedge against rising inflation in the past. Inflation is calculated by following the prices of goods and services that frequently contain commodities, as well as products that are closely tied to commodities. Oil and other energy-related commodities have a particularly strong link to inflation (see above). When inflation accelerates, industrial and precious metals prices tend to rise as well.
Commodities, on the other hand, have significant disadvantages, argues Haworth. They are more volatile than other asset types, provide no income, and have historically underperformed stocks and bonds over longer periods of time.
As it comes to real estate, when the price of products and services rises, property owners can typically increase rent payments, which can lead to increased profits and investor payouts.
What effect does inflation have on spending?
As the rate of inflation rises, people are more prone to store products and make financial decisions based on emotions, which can drive prices further higher. For months, prices have been climbing on almost everything. Inflation has reached its highest point in decades.
What impact does inflation have on investment decisions?
Over time, currencies in nations with greater inflation rates devalue more than those in countries with lower rates. Investors may move their money to markets with lower inflation rates since inflation erodes the value of investment returns over time.
What effect does inflation have on stocks?
Consumers, stocks, and the economy may all suffer as a result of rising inflation. When inflation is high, value stocks perform better, and when inflation is low, growth stocks perform better. When inflation is high, stocks become more volatile.
What three impacts does inflation have?
Inflation lowers your purchasing power by raising prices. Pensions, savings, and Treasury notes all lose value as a result of inflation. Real estate and collectibles, for example, frequently stay up with inflation. Loans with variable interest rates rise when inflation rises.
In what ways does inflation benefit investors?
According to Bloomberg statistics, the ’10-year break-even rate’ (a key gauge of market inflation expectations in the United States) increased to 2.2 percent in early February, the highest level since 2014. Many market analysts predict that worldwide inflation will rise by the end of 2021. What does this mean for your investments, though?
Inflation is defined as a steady rise in prices and a decrease in the purchasing power of money. Inflation reduces the purchasing power of money and savings. Deflation is the polar opposite of inflation, which occurs when prices fall due to a lack of demand for services in a stagnant economy. Low GDP and growing inflation are referred to as stagflation.
The Covid-19 pandemic has slowed the world economy, potentially leading to deflation. Lockdowns implemented by various governments have resulted in lower demand for goods in critical economic sectors such as air travel, tourism, and restaurants, to name a few. The current atmosphere is potentially hazardous due to the combination of high debt levels and deflation.
Inflation is calculated by comparing the prices of a variety of things in an imagined shopping bag over time and calculating the average price rise (or decrease). Statistics SA keeps track of inflation in South Africa. Inflation is measured in percentages, so if the price of our imaginary shopping bag increases by 3% from one year to the next, inflation is said to be 3%.
The reasons of inflation are the subject of numerous hypotheses. Economists distinguish between ‘cost-push inflation’ (increases in the cost of goods due to increases in the cost of production) and ‘demand-pull inflation’ (increases in the cost of goods owing to increases in the cost of production) (an increase in demand for goods relative to supply, leading to higher prices).
Inflation can also occur when the government prints more money than the country’s wealth justifies, leading the currency’s value and purchasing power to fall.
Inflation that is moderate is generally thought to be a desirable thing because it is linked to economic growth. Household items and salary prices are rising in lockstep. It facilitates debt servicing (for both individuals and governments), thereby shifting wealth from creditors to debtors. However, when inflation becomes difficult to manage and prices rise at an unsustainable rate (think Zimbabwe), the purchasing power of money and the real worth of savings and pensions are both destroyed.
Unexpected inflation hurts lenders since the money they are paid back has less purchasing power than the money they lent out. Borrowers, on the other hand, gain from unanticipated inflation because the money they repay is less valuable than the money they borrowed.
It’s easy to see why heavily indebted countries (such as the United States) would want controlled inflation, as this would gradually ‘inflate away’ government debt. Government-issued inflation-linked bonds, on the other hand, operate as a brake on inflation; investors receive ‘inflation plus interest rate’ yields, providing a strong incentive to keep inflation under control.
What is the ideal level of inflation, and what can governments and central banks do if inflation threatens?
In industrialized markets, a 2% inflation rate, stable prices, maximum output, and full employment are considered ideal. Emerging market inflation is higher than developed market inflation because emerging market GDP growth is higher on average. Inflation targeting was first implemented in South Africa in the early 2000s, and the Reserve Bank has been aiming for a rate of inflation between 3% and 6% for the past 20 years. To achieve this goal, a variety of monetary policy tools are used, most notably the management of short-term interest rates.
According to Statistics South Africa, the average annual inflation rate for 2020 was 3,3 percent, the lowest since 2004 (1.4%), and the second-lowest since 1969. (3,0 percent ). A firmer rand, which gained from R7,56/$ in 2003 to R6,45/$ in 2004, was one of the reasons for low inflation in 2004, according to the South African Reserve Bank at the time (annual average).
Between 1913 and 2020, the average rate of inflation in the United States was 3.2 percent, with strong inflation periods during World War I, World War II, and the 1970s.
Rapidly rising inflation is a red flag for governments, who normally respond by raising short-term interest rates, in the hopes of reducing credit demand and preventing the economy from overheating. Longer-term rates (yields) rise in tandem with interest rates, and because bond prices and yields move in opposing directions, rising yields imply declining prices, resulting in decreased principal value for bonds and other fixed-income instruments.
When ‘loaned’ to banks or fixed interest fund managers, cash investments (money put in the bank in fixed interest accounts, short term vehicles such as money market funds or bond funds) generate income for investors. The nominal interest rate on a bond does not account for inflation, therefore an investor will only get the nominal rate if inflation is zero. The real interest rate on a bond is obtained by subtracting the nominal interest rate from the real interest rate. For instance, if the nominal interest rate is 4% and the inflation rate is 3%, the real return/interest rate is 1%.
When inflation rises, cash investments, as previously said, perform poorly. This is due to the fact that the purchasing power of the expected future cash flows for the cash investment diminishes with time.
Inflation and rising interest rates are two factors that have a detrimental impact on fixed-income investment returns. As investors desire higher yields to compensate for inflation risk, a prolonged rise in either of these causes rates throughout the yield curve to climb, causing bond prices to fall.
To preserve wealth during inflationary periods, investors have traditionally invested in real assets having a fixed or known value, such as inflation-linked bonds, securitized debt, property, commodities, and chosen shares.
In an inflationary environment, not all stocks provide safety. Companies that are well-positioned to pass on inflation to their consumers are more likely to withstand the storm than those that are over-indebted and require significant capital expenditures.
In recent years, central banks have pumped huge amounts of relief funds into the economies of many countries. Some of this cash has found its way into the bond and stock markets, causing prices to rise above their true value. Lower real interest rates have been a tailwind for equities in recent months, propelling several of the world’s top stock exchanges to record highs.
Economists believe that when the deflationary cycle ends, there will likely be a rise in inflation, which would be prompted in part by the US government’s repeated relief packages, which are intended to boost demand for goods and services and therefore guide the economy away from deflation.
Restaurants, hotels, airlines, and other hard-hit industries are expected to rebound and demand for their services will increase during the pandemic, according to analysts. Pent-up demand may encourage customers to spend some of their additional savings (typically obtained through government assistance programs), resulting in inflation.
If inflation rises, real interest rates may climb without further help from central banks, reversing recent stock market highs.
This key inflection moment is an opportunity for Rosebank Wealth Group to uncover new trends in regions, asset classes, industries, and strategies. Our connections and contacts with important stakeholders enable us to spot possible opportunities for investing and protecting client assets over the long term.
Quiz on how inflation affects investments.
Inflation can suffocate investment opportunities since savings can be worth considerably less when repaid than initially lent, and the real rate of interest may be low.
When inflation rises, what happens?
The cost of living rises when inflation rises, as the Office for National Statistics proved this year. Individuals’ purchasing power is also diminished, especially when interest rates are lower than inflation.
What causes inflation and what does it do?
- Inflation is the rate at which the price of goods and services in a given economy rises.
- Inflation occurs when prices rise as manufacturing expenses, such as raw materials and wages, rise.
- Inflation can result from an increase in demand for products and services, as people are ready to pay more for them.
- Some businesses benefit from inflation if they are able to charge higher prices for their products as a result of increased demand.