“While cash isn’t a growth asset, it will typically stay up with inflation in nominal terms if inflation is accompanied by rising short-term interest rates,” she continues.
CFP and founder of Dare to Dream Financial Planning Anna N’Jie-Konte agrees. With the epidemic demonstrating how volatile the economy can be, N’Jie-Konte advises maintaining some money in a high-yield savings account, money market account, or CD at all times.
“Having too much wealth is an underappreciated risk to one’s financial well-being,” she adds. N’Jie-Konte advises single-income households to lay up six to nine months of cash, and two-income households to set aside six months of cash.
Lassus recommends that you keep your short-term CDs until we have a better idea of what longer-term inflation might look like.
What effect does inflation have on cash?
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.
Is it wise to keep cash on hand during an inflationary period?
TIPS (Treasury Inflation-Protected Securities) are government bonds that provide inflation protection. The government notes that “the principal of a TIPS increases with inflation and declines with deflation, as assessed by the consumer price index.”
Think about value stocks in the consumer staples arena
Snigdha Kumar, Digit’s head of product operations, argues that investing in staples like food and energy, which are always in high demand, is a good idea since staples are necessities, and companies providing them can raise prices while riding the inflation wave.
Look for tax efficienciecs
“Look for tax efficiency in your brokerage account to help you resist inflation,” Carrigg advises. To enhance tax efficiency, taxable accounts should be used for investments that lose less of their returns to taxes, while tax-advantaged accounts should be used for investments that lose more of their returns to taxes. In other words, if you want to keep more of your money, tax-efficient investing will reduce your tax burden, allowing you to pay less tax on the money you earn from your assets. “Open a Roth IRA and contribute the maximum amount possible because tax-free accounts can be extremely useful,” Carrigg advises.
Look at companies that can raise prices relatively easily without harming the business
Warren Buffett has always advocated for investing in businesses with modest capital requirements, particularly during inflationary periods. Look for companies that have the “capacity to boost prices rather simply,” as Buffett put it. If you can invest in a company that can raise its pricing without losing revenue, Buffett recommends it since it generates profit.
Don’t keep an excess of cash on hand
“If you have a lot of liquid cash on hand beyond what you’ll need for an emergency fund, you should consider investing it.” “While the stock market is currently low, that investment can generate a lot greater interest rate in the stock market than it would in a savings account over a lengthy period of time,” explains Chanelle Bessette, banking consultant at NerdWallet.
That said, don’t neglect your savings
It’s critical to have an emergency fund: “Open a savings account and deposit three to six months’ worth of spending in it that will only be used for emergencies,” Carrigg advises. Despite the fact that most savings account rates are low, “It’s much better to earn some interest than none at all,” Bessette adds. “As a result, consumers should look for high-yield online savings accounts that typically provide rates significantly higher than the industry average.”
When it comes to inflation, should you purchase or sell?
During a 2015 shareholder meeting, Berkshire Hathaway’s Chairman and CEO noted that “the best firms during inflation are the ones that you buy once and then don’t have to keep making capital investments thereafter,” while “any business with heavy capital investment” should be avoided. He recommends real estate as a good investment during inflation since you can buy it once and profit from the increase in value; nevertheless, he advises against utilities and railroads as suitable investments during inflation.
Buffett also said that the best way to protect against inflation is to invest in yourself and your skills: “If you’re the best teacher, if you’re the best surgeon, if you’re the best lawyer, you’ll get your share of the national economic pie regardless of the value of whatever the currency may be,” he said at a 2009 shareholder meeting. “The second best protection is a good business,” he says, referring to a corporation whose products are in high demand even if the company has to hike prices.
Buffett may have spelled it out as clearly as ever in a 1981 letter to shareholders, writing that companies that tend to withstand an inflationary environment “must have two characteristics: (1) an ability to increase prices relatively easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) an ability to accommodate large dollar volume increases in business (often referred to as “capacity expansion”).
All of this said, maybe the most important lesson that individual investors can take away from Buffett is that instead of trying to pick individual stocks, whether we’re in an inflationary environment or not, you should stick to the tried-and-true strategy of having and holding an index fund. Buffett stated at a shareholder meeting in 2021 that “I do not believe the typical person can pick equities,” and that the S&P 500 index fund is one to “have for a long, long time to people.”
Inflation favours whom?
- Inflation is defined as an increase in the price of goods and services that results in a decrease in the buying power of money.
- Depending on the conditions, inflation might benefit both borrowers and lenders.
- Prices can be directly affected by the money supply; prices may rise as the money supply rises, assuming no change in economic activity.
- Borrowers gain from inflation because they may repay lenders with money that is worth less than it was when they borrowed it.
- When prices rise as a result of inflation, demand for borrowing rises, resulting in higher interest rates, which benefit lenders.
Where should I invest my money to protect against inflation?
Most investors who are at least a few decades away from retirement are likely to be overweighting equities in their portfolios. According to Elliott Appel of Kindness Financial Planning in Madison, Wisconsin, keeping a globally diversified basket of stocks is a prudent location to put your money when interest rates are projected to rise.
“Companies can pass on price hikes to consumers as inflation rises, increasing their earnings,” explains Appel. “Stock prices should rise as a result of this over time.”
How do you protect yourself from inflation?
If rising inflation persists, it will almost certainly lead to higher interest rates, therefore investors should think about how to effectively position their portfolios if this happens. Despite enormous budget deficits and cheap interest rates, the economy spent much of the 2010s without high sustained inflation.
If you expect inflation to continue, it may be a good time to borrow, as long as you can avoid being directly exposed to it. What is the explanation for this? You’re effectively repaying your loan with cheaper dollars in the future if you borrow at a fixed interest rate. It gets even better if you use certain types of debt to invest in assets like real estate that are anticipated to appreciate over time.
Here are some of the best inflation hedges you may use to reduce the impact of inflation.
TIPS
TIPS, or Treasury inflation-protected securities, are a good strategy to preserve your government bond investment if inflation is expected to accelerate. TIPS are U.S. government bonds that are indexed to inflation, which means that if inflation rises (or falls), so will the effective interest rate paid on them.
TIPS bonds are issued in maturities of 5, 10, and 30 years and pay interest every six months. They’re considered one of the safest investments in the world because they’re backed by the US federal government (just like other government debt).
Floating-rate bonds
Bonds typically have a fixed payment for the duration of the bond, making them vulnerable to inflation on the broad side. A floating rate bond, on the other hand, can help to reduce this effect by increasing the dividend in response to increases in interest rates induced by rising inflation.
ETFs or mutual funds, which often possess a diverse range of such bonds, are one way to purchase them. You’ll gain some diversity in addition to inflation protection, which means your portfolio may benefit from lower risk.
Is inflation beneficial to 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.