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 will inflation have on the stock market?
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.
Why do stocks rise when inflation is high?
“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.”
Why do equities fall in value as inflation rises?
Inflation is one of the many factors that keeps traders awake at night (I know, we’re a dull bunch).
The mere mention of the word is almost enough to put most people to sleep. It also sounds like an unpleasant ailment (“I’m afraid you have inflation”). But don’t worry, we aren’t here to lecture you about economics. We simply want to understand why investors are terrified of inflation. In other circumstances, it’s enough to pull the entire stock market down.
What is inflation?
In its most basic form, inflation is just the rise in prices. Remember when you could get a Freddo for ten pence? It currently costs around a pound. That’s what inflation is.
And have you seen how train tickets increase in price every year? Inflation, to be precise. The inflation rate is defined as a percentage increase in prices of 2%.
It’s easy to see how this would irritate a typical customer. We don’t want to pay a higher price for our Freddos. But why should the stock market be concerned about this? After all, if prices rise, corporations should make more money, right?
Correct. However, inflation has a slew of negative consequences for businesses.
The dark side of inflation ?
To begin with, inflation has an influence on more than just the things on our shelves; it also has an impact on the raw materials used behind the scenes. As a result, businesses may charge greater prices, but they also spend more.
The second issue has to do with our pay. If wages do not rise, we will all be poorer as a result of the price increase. As a result, individuals purchase less items. Assume you frequent the pizzeria every weekend, but inflation sets in. Your pizza and beer are now 5 more expensive than before. You might decide to stay indoors next Saturday and order a Pot Noodle (don’t make that look; you know you like it).
In other words, when inflation rises, people will no longer be able to afford all of the things they formerly could. As a company’s sales diminish, profit declines as well.
And those profits are worth even less…
There’s a greater reason why the markets are terrified of inflation. The worth of a corporation is determined by its future earnings estimates for an investor. However, when inflation rises, the shareholder’s profits will purchase less and less. As a result, each share is thought to be worth less.
Let me give you an example if that sounds like nonsense. Let’s say I predict a profit of $7 per share for Facebook next year. If there is no inflation, that $7 will be worth the same in a year as it is now. With my $7, I’ll still buy the same amount of pizza.
Let’s pretend there’s a 2% annual inflation rate. Pizza will increase by 2%, which means I won’t be able to get as much yummy, cheesy, pepperoni bliss for my $7. If inflation rises to 3%, my $7 will be worth even less, and so on.
The role of central banks
The rise in prices is also concerning for another reason: when inflation crosses specific thresholds (usually 2%), central banks raise interest rates to contain it.
Don’t doze off right now since this is critical (and drives the markets into a frenzy).
If inflation depreciates the value of your money, we need a way to combat it. Raising interest rates accomplishes this. Consider it a see-saw. Interest rates can bring inflation back down if it becomes too high. How?
The cost of borrowing money is represented by the interest rate. As a result, as the interest rate rises, the value of money grows as well. WTF? Let’s say you lend your friend 100 with a 5% interest rate. When he pays up, you’ll get 105. However, if the interest rate is higher, say 10%, you will receive 110. To put it another way, your money is now *worth* more.
As a result, central banks raise interest rates to keep inflation under control. However, this action has a number of negative consequences for the economy and markets.
First, as interest rates rise, your bank will raise your credit card and mortgage rates (if you have a variable rate). This means you’ll have less money to spend, and that lonely Saturday night Pot Noodle will become a melancholy habit. But don’t worry, we’re all broke, therefore we’re all doing it! Companies, with the exception of Pot Noodle, earn less and make even fewer profits as a result.
Second, banks don’t simply boost rates for individuals; they also raise rates for businesses. While you may have a mortgage and a few thousand dollars on your credit card, some businesses are owed millions or billions of pounds. If a firm owes 1 billion in debt and the bank raises the interest rate by merely 0.5 percent, the company will owe an additional 5 million at the end of the year. As a result, profits are down yet again.
Wrapping it up
In other words, price increases have the potential to trigger a domino effect that sends entire economies into recession. It has an impact on us ordinary mortals when we buy pizza, Freddos, and train tickets, but it also has an impact on publicly traded firms and their stockholders.
That’s why investors worry about inflation, and it’s something you should consider as well.
All views, opinions, and analysis stated in articles are solely those of the author and do not reflect BUX’s position. These articles should not be considered as financial advice because neither BUX nor the author provide it.
What is creating 2021 inflation?
As fractured supply chains combined with increased consumer demand for secondhand vehicles and construction materials, 2021 saw the fastest annual price rise since the early 1980s.
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.
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.
Is inflation detrimental to 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.