The possibility of losing buying power when the value of your investments fails to keep pace with inflation.
What exactly do you mean when you say “inflation risk”?
The risk of inflation undermining an investment’s performance, the value of an asset, or the purchasing power of a stream of income is referred to as inflationary risk. The nominal return is calculated by looking at financial results without taking inflation into consideration.
For dummies, what is inflation risk?
Inflation is a risk that stock investors must consider. Inflation occurs when the quantity of money is artificially increased, resulting in an excess of money being utilized in exchange for goods and services. Inflation is visible to customers as increasing costs for products and services.
Purchasing power risk is another term for inflation risk. This simply means that your money will not buy as much as it once did. A dollar that bought you a meal in 1980, for example, barely purchased you a candy bar a few years later. This risk means that the value of your investment may not keep up with inflation, which is bad news for you, the investor.
Assume you have money in a bank savings account that is currently yielding 4%. This account is adaptable; if the market interest rate rises, so does the rate you earn in your account. Both financial and interest rate risk are eliminated from your account. But what if the rate of inflation is 5%? You’re out of money at that moment.
Inflation is a real and severe worry that should not be overlooked when evaluating risk in your investing selections.
Inflation is a sort of risk.
Inflation risk refers to when the price of products and services rises faster than expected, or when the same amount of money has less purchasing power. Purchasing Power Risk is another name for inflation risk.
What is the impact of inflation risk?
Consumer spending, company investment, and employment rates are all affected by inflation, as are government programs, tax policies, and interest rates. In order to invest successfully, you must first understand inflation. Inflation can diminish the value of your investment returns.
What is the impact of inflation on the financial markets?
Inflation is usually thought of being a negative trigger for equity markets. The causes are not difficult to find. Inflation leads to increasing living costs and, as a result, diminished purchasing power. People earn less in real terms as inflation rises, resulting in smaller returns net of inflation. Second, greater inflation leads to higher interest rates, which affects the cost of equity. In the following paragraphs, we’ll go over this topic in further depth. There are occasions when inflation has a favorable impact on the equities markets.
So, how does inflation affect the Indian stock market? Is there a link between investment and inflation? Do people invest more when inflation is high or less when inflation is low? What is the impact of inflation on stock market indices, particularly the Nifty and Sensex? Let’s take a closer look at each of these points.
What exactly do we mean when we say “inflation”? Inflation is the rise in the price of goods and services over time. In India, retail inflation is monitored by the Consumer Price Index (CPI) as well as producer inflation, which is known as WPI inflation. Normally, the CPI is a more accurate and meaningful measure of consumer inflation and buying power. Let’s look at an example to better grasp this.
Particulars
Inflation rate of 5%
Inflation rate of 7%
Inflation rate of 10%
Amount at the end of a yearRs.100Rs.100Rs.100Rs.100Rs.100Rs.100Rs.100Rs.100Rs.100Rs
0.950.930.90 inflation adjustment factor
Rs.95Rs.93Rs.90Rs.95Rs.93Rs.90Rs.95Rs.93Rs.90Rs.90Rs.90Rs.90Rs.90
As shown in the table above, as inflation rises, the present value of the money you will receive in the future decreases. This is referred to as the present value of money. When inflation is 5%, your Rs.100 receivable after a year is worth Rs.95 today, however when inflation is 10%, your Rs.100 receivable after a year is only worth Rs.90 today. When your purchasing power decreases, you can buy fewer things for the same amount of money. This is typically unfavorable for consumer-driven businesses such as FMCG and consumer durables, since people’s ability to pay declines, forcing these companies to decrease prices and cut profits.
What happens to bonds and stocks when inflation rises? Let’s start with bonds. Interest rates or bond yields will rise in lockstep with inflation when the rate of inflation rises. In the previous six months, we’ve seen this dynamic play out, with bond rates rising by 125 basis points in concert with rising inflation predictions. When bond rates rise, bond prices fall, ensuring that the YTM of these bonds remains relatively constant. Bond holders, such as banks and people who invest in mutual funds, suffer capital losses when bond prices decline. As a result, rising interest rates are usually bad for banks.
What about stocks? When inflation rises and interest rates rise, the cost of capital rises as well. The cost of capital is the sum of the cost of debt and the cost of equity. When bond yields rise, the cost of capital rises as well, lowering the value of the company’s future cash flows. We all know that shares are valued by discounting future cash flows. When the rate of discounting increases, equity prices decrease.
While inflation is inherently negative for bonds and stocks, we must not overlook a beneficial side of rising inflation. In most cases, increased inflation equates to faster GDP growth. Inflation has been on the rise over the past year, dating back to the beginning of 2017. During the same time frame, GDP growth has showed signs of bottoming out, corporate earnings have shown green shoots of recovery, and stock market indices have risen by more than 20% year-to-date. The good news about inflation is that it is a leading indication of economic growth. Even in the United States and Japan, the major economic effort is to get inflation back to 2%. That is meant to be the growth-inducing cut-off point. In reality, if you look at global growth and even India’s growth over the previous 20 years, you’ll notice that GDP has never expanded significantly while inflation was low. While too high inflation can have a negative impact on purchasing power, a certain level of inflation is essential to motivate producers and businesses.
Inflation that exceeds a tolerable level is the true issue. Inflationary pressures pose some concerns, but they are also necessary for growth. The macroeconomic key is held by this balance.
What makes inflation a financial concern?
Inflationary pressures produce price increases, which reduces the real return on a particular investment. Inflation risk has an impact on portfolio planning, particularly when it comes to retirement spending. When living off of investments, the higher the inflation rate, the less purchasing power a retiree will have.
Inflation destroys debt in what ways?
Your dollar would be worth 95% less today than it was in 1915 if you kept it in cash for the previous 100 years. This is due to the fact that the value of your money depreciates over time and may buy you less each year due to inflation.
Debt operates in a similar way. In nominal terms, the debt’s worth does not change (assuming you do not pay it off). However, the value of that loan depreciates over time in the same manner that currency does. In today’s dollars, $100 in debt would be worth less than $10 over the last 100 years. This is why using leverage during inflationary periods is so valuable. It lowers the value of your loan over time.
Deflation is different when it comes to debt
While inflation gradually erodes the value of debt, deflation has the reverse effect. It increases the debt’s value over time. This is how a mortgage can deplete your property value. Here’s another look at one of the graphs from before.
While the cost of goods and services is falling, the cost of debt is staying the same. In fact, it improves in contrast. This is why, if there is a negative inflation rate, it is critical to minimize or erase your debt.
Help me! Deflation is confusing
It can be difficult to understand the distinction between future dollars and today’s dollars. Especially if we haven’t dealt with deflation before. Another approach to demonstrate how deflation can effect your investment property mortgage is to consider the following scenario:
Let’s imagine you wanted to buy an investment property for $125,000 today and decided to take out a $100,000 mortgage on it. Most mortgage contracts are relatively similar in that, depending on the sort of mortgage you have, you must make either fixed or variable installments.
In this case, there is no inflation, but the bank adds $3,000 to the balance of your mortgage each year, in addition to any interest payments you due. You would pay the interest due at the conclusion of year one, and your principal sum would be boosted to $103,000. Do you find this to be an appealing proposition?
This means that if you have a 3% interest rate, you will owe a net of 6% every year. 3% in interest and 3% extra on top of the principal.
Hopefully, you’ve realized that while you’re employing leverage, deflation hurts a lot.
To summarize, when there is deflation, the value of your real estate declines, your cash flows drop, and if you are utilizing leverage, those drops are compounded. Remember, if there is deflation, you should not have a mortgage.
We have had inflation for over 50 years, why should you worry about deflation?
We can assume that if housing prices are a good hedge against inflation, they will also be a strong hedge against deflation. However, why should we be concerned about deflation?
Is there a market risk of inflation?
Markets would be challenged by sustained inflation. Financial markets would be challenged if inflation remained high for a lengthy period of time. Higher inflation usually means higher interest rates, which has led to a sell-off in bond markets.
Is financial stock inflation beneficial?
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.