The current economic disaster, combined with the massive fiscal and monetary policy responses, could push inflation in the developed world above the low single digits for the first time in decades. The regime of low and stable inflation is also jeopardized by rising geopolitical tensions, which contribute to onshoring, a lack of faith in the banking system, and decreased oil costs. What should an investor do in the face of the increased risk of extreme monetary outcomes?
Warren Buffett wrote an article for Fortune magazine in 1977 called “How Inflation Swindles the Equity Investor.” In the article, he argues that, contrary to popular belief, equities are not immune to price increases in general. In the decades leading up to 1977, corporate America’s return on equity had been stagnant at roughly 12%, insensitive to changes in the rate of inflation. “…stocks, in economic substance, are really very comparable to bonds” because of this stable “coupon.”
Buffett uses a five-factor DuPont ROE analysis (see figure below) to argue that in an inflationary environment, ROE should remain steady because none of the DuPont components are likely to improve. Asset turnover (sales/assets) may temporarily grow as businesses raise prices ahead of asset inflation mark-to-market, but the corporation’s working capital and fixed assets will eventually have to rise in lockstep with the price level. In an inflationary environment, shareholders may need to reinvest a growing portion of earnings to maintain productive capacity, whereas bondholders can take the coupon and do whatever they want with it. Bondholders also benefit from a defined maturity date, which allows them to renegotiate the conditions of their investment, whereas equity is a perpetual vehicle.
How does inflation effect investors?
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 impact does inflation have on the stock market?
In the past, high inflation has been linked to lower equity returns. In periods of high inflation, value stocks outperform growth stocks, and growth stocks outperform value stocks in periods of low inflation.
What is inflation beneficial to investors?
“Investors should continue to keep equities since stocks normally outperform in times of inflation, especially if it is accompanied by growth.” Consumer staples stocks, such as food and energy, perform well during inflation because demand for staples is inelastic, giving these companies more pricing power because they can increase their prices more quickly than other industries.”
Opt for stocks and TIPs, says Leanne Devinney, vice president of Fidelity Investments
“Diversifying between different sorts of investments is a solid idea.” For example, equities, rather than bonds, have a better track record of keeping up with inflation over time. Consider Treasury Inflation-Protected Securities (TIPS) and high-yield bonds, which are both inflation-resistant fixed income investments. It may also assist in reducing exposure to more inflation-sensitive investments, such as some treasury bonds.”
Change up how you deal with your cash, says Pamela Chen, chartered financial analyst at Refresh Investments
“When there is a rise in inflation, it is more vital to invest funds. During inflationary periods, when prices for things rise, cash loses purchasing power, and one dollar buys less than it used to. Invest your money to generate a return that will help you avoid the inflationary bite, or to achieve a return that will stay up with or exceed inflation.”
Warren Buffett’s inflation protection strategy
TIPS, or Treasury Inflation-Protected Securities, are another investment Buffett recommends for investors concerned about rising inflation. TIPS pay a set interest rate twice a year to investors, but the principal is adjusted for inflation using the Consumer Price Index.
Invest in yourself and be the best at what you do
Buffett reminded shareholders in 2004 that investing in your own talent is one of the finest ways to sustain your purchasing power over time. The top surgeon or lawyer in a city or town benefits from an education paid for in “old dollars,” but may charge current dollars for their services without having to re-educate.
Consider adding a new skill to your rsum by using internet resources or enrolling in a local institution. Advanced degrees can be costly, but they can also help you expand your knowledge base and make you a valuable employee in the future. Over time, increasing your worth to your employer and its clients will help you command a fair portion of the profits.
Steer clear of traditional bonds
“In his 2020 letter to Berkshire shareholders, Buffett stated, “Bonds are not the place to be these days.” Bond investors could be severely harmed in an inflationary climate because interest rates are still near historic lows.
A 10-year bond yielding 2%, according to Buffett, is comparable to paying 50 times earnings for a corporation, with the exception that the bond’s earnings cannot expand.
“Fixed-income investors around the world, whether pension funds, insurance firms, or pensioners, have a grim future,” he predicted.
Limit your wants
Charlie Munger, Buffett’s business partner and vice chairman of Berkshire Hathaway, has his own ideas about how to deal with periods of excessive inflation: “Not having a lot of stupid needs in your life is one of the great defenses against being concerned about inflation,” Munger told Berkshire shareholders in 2004. “To put it another way, if you haven’t created a lot of false demand to drown in consumer things, you have a strong barrier against life’s vicissitudes.”
Consider using a budgeting software to help you keep track of your spending. This can help you understand how you’re currently spending your money and may help you spot issue spending patterns before they become a habit.
What effect does inflation have on private equity?
Inflation is a critical risk for the private equity business, and several firms, notably Brookfield Asset Management Inc., KKR & Co. Inc., EQT AB (publ), and Ares Management Corp., have expressed fear that it will continue to climb.
Mark Weinberg, managing partner of Brookfield’s private equity group, said at SuperReturn North America earlier this month that the issue is “on all of our minds” along with supply chains.
“It appears to be temporary since, hopefully, we are emerging from the crisis and everything will return to normal. However, given what’s going on at ports throughout the world, as well as the cost of energy, commodities, and shipping, it doesn’t appear to be a passing fad. So that appears to be a serious problem “Added he.
Inflation risk is also a concern for limited partners. According to a recent poll conducted by placement firm Eaton Partners LLC, 89 percent of limited partners (LPs) are concerned about rising inflation in 2022.
Cameron Joyce, vice president of Preqin’s Research Insights, said S&P Global Market Intelligence, “The most crucial impact of inflation is the influence it might have on interest rates.” “Given the long-term nature of investing, the longer-term interest rate is more relevant to private equity and private capital.”
“Higher inflation rates could lead to a sell-off in longer-term bond yields. This has a variety of implications for private equity pricing because… your discount rate and future cash flow are both greater.”
Because technology businesses are currently trading at high valuations and thus sensitive to increased discount rates, they are particularly vulnerable to increases in inflation, according to Joyce.
Speaking at the SuperReturn North America event, Pete Stavros, KKR’s partner and co-head of North American private equity, acknowledged that inflation is a key risk. If the trend continues, he believes interest rates will have to climb.
The rise in shipping rates and the cost of goods owing to supply chain disruption, the labor shortage, which is driving up salaries, and the shift to renewable energy, which is cutting oil production and pushing up oil prices, are all factors driving inflation, according to Stavros.
He went on to say, “We’re looking for core inflation to settle higher, maybe 3 percent plus, against 1.5 percent historically.”
According to Joyce of Preqin, private equity has exhibited no significant indicators of slowing down its activity. In reality, the industry appears to be in good shape right now.
“Inflation is perhaps the single biggest risk we have right now, although opinions on it are split. Some investors believe this is something that will resolve itself when we emerge from the pandemic and all of the economy’s frictional concerns are resolved. However, other investors regard this as the beginning of a longer-term process.”
What is the impact of inflation on financial planning?
Because prices are expected to rise in the future, inflation might erode the value of your investments over time. This is particularly obvious when dealing with money. If you keep $10,000 beneath your mattress, it may not be enough to buy as much in 20 years. While you haven’t actually lost money, inflation has eroded your purchasing power, resulting in a lower net worth.
You can earn interest by keeping your money in the bank, which helps to offset the effects of inflation. Banks often pay higher interest rates when inflation is strong. However, your savings may not grow quickly enough to compensate for the inflation loss.
What impact does inflation have on businesses?
Inflation decreases money’s buying power by requiring more money to purchase the same products. People will be worse off if income does not increase at the same rate as inflation. This results in lower consumer spending and decreased sales for businesses.