Most people have an intuitive understanding of inflation. It is generally in the context of their regular purchases. Like for like, they expect that over time, they will be able to purchase lesser and lesser than today, for the same amount of money. The affect inflation has on investments can be confusing and frustrating.
The reality is that inflation always exists due to the way our monetary policy is. As a matter of fact, the inflation rate for the last 20 years was 3.10%. Currently, the inflation rate has risen and is on pace with 6% year over year.
So what does that inflation have to do with investment?
The short answer is that inflation is a major threat to investments because it dilutes returns and erodes the principal capital. Some investments such as stocks have historically been able to outpace inflation, others like saving accounts have not. This is because the return must be greater than the rate of inflation.
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To make stuff more complicated, some investments like gold or commodities may perform better in a rising inflation environment than a lower inflation environment. The purpose of this article is to explore inflation and its effect on investments. Please feel free to check out our list of 3 inflations stocks.
- 1 Consumer Price Index (CPI)- Measuring inflation
- 2 What are the main effects of inflation?
- 3 Inflation can erode your investments
- 4 What are the contributors to inflation?
- 5 Major contributors:
- 6 How Can You Plan for Inflation?
- 7 What investments do well during inflation?
- 8 Your time horizon also affects your asset allocation
- 9 How to win against inflation
Consumer Price Index (CPI)- Measuring inflation
The Bureau of Labor Statistics officially measures the prices of goods and services over time. This information goes into the creation of the Consumer Price Index (CPI), which is a composite of a large number of items like clothing, food, gasoline, and other items commonly consumed by people. Its objective is to issue an index that represents the average cost of goods and services as compared to a previous point in time.
As an example, the CPI in January 2020 was 2.3, which means that the overall increase in cost for consumers was 2.3 percent. If they were spending $100 a month on their groceries a year back, they would now be spending $102.30 on the same set of goods and services.
What are the main effects of inflation?
The main effects of inflation are the decreased purchasing power of money and the increased cost of goods. Things like energy and food are often the first to go up in price. However, consumers’ income is generally lagging behind the increased costs.
What effect does inflation have on the purchasing power of a dollar?
The answer is that inflation has the effect that it erodes the value of the currency, in this case, the dollar. The way this is measured is through the Consumer Price Index (CPI) which takes into account the spending of consumer goods and services.
Inflation can erode your investments
A four percent inflation annually rate would erode the value of a dollar down to $0.44 in just 20 years. Inflation also works against your investments. Consider your real rate of return, which is determined by figuring in inflation. The price of a loaf of bread that costs $3 today would soar to more than $7 under inflation. In order to achieve your long term goals, you need to take inflation seriously. If you don’t then you may see that you are coming up short because inflation outpaced your investment strategy.
Why do goods and services increase?
The short answer is that inflation causes the value of the currency to decrease which causes the cost of goods and services to increase. In this case, the value of goods and services is inversely correlated to currency value.
What are the contributors to inflation?
There are many factors that contribute to inflation, like demand and supply, taxation policies, and even the lending environment. Different parts of the basket may move differently. Some may even decrease.
For example, because of the Covid-19 pandemic and consequent lifestyle changes, some goods have fallen out of favor. If people cannot travel, the need for buying cars will reduce. That fall in demand might end up reducing the price of cars as manufacturers try to clear old inventory.
Price of energy
Most transportation systems we have built need energy to run, mainly oil. In a global economy, goods need to be transported across long distances to reach the eventual consumer. The fall in oil prices in recent months is an indicator of lower demand for oil, arising out of a lower need to transport goods, in turn because of lower consumer demand. In the coming days, expect oil prices to move up, as the economic engines start rolling again.
The interest rate is often used by the Federal Reserve (Fed) as a key instrument of monetary policy. Keeping interest rates low incentivizes borrowing, as the interest costs are lower, which in turn spurs demand.
We may have increasingly procured goods from overseas in search of the best prices, but factories look poised to return to the American mainland. This could increase the cost of production and the price paid by consumers.
How Can You Plan for Inflation?
Inflation is the primary reason many people keep some of their money away from savings at a bank. Investments that pay a fixed rate such as bonds, CDs, and annuities can be hurt by inflation. Unfortunately, this hurts many seniors that are trying to live off interest payments.
Investors can plan to do 3 things. The first is that they can ignore the inflation risk. The second is that they can invest in more safe fixed investments such as CDs, but realize that the value will not keep up with inflation. The third option to incorporate more risky investments such as stocks that keep up with inflation.
What investments do well during inflation?
Inflation can impact future returns across asset classes. While we will cover several asset classes, the broad theory is that investments that deliver fixed cash flows will be poorer with inflation, while those that have the ability to adjust cash flows, such as rentals and commodities, will have the best chance of keeping pace and beating inflation. Looking at the rising inflation in the 1970s, real estate of existing homes out-performed inflation by roughly 34%. However, gold locked in over 2000% returns.
|Asset||Rising Inflation Relationship|
|Emerging Market Stocks||Negative|
|Treasury Inflation-Protected (TIPS)||Mixed|
|Precious Metals (Gold, Silver, etc.)||Positive|
Is inflation good or bad for savings?
Fixed returns from savings accounts can leave you poorer in an inflationary environment. As mentioned earlier, adjustable cash flows can adjust with inflation whereas fixed flows cannot. During your working life, your earnings should be adjustable for inflation and rise with it. Post-retirement savings, however, may not be. Hence it is advisable to build that additional cushion in your savings that can withstand the erosion of value caused by inflation.
Fixed income investments
The strength of fixed income investments, of paying steady, fixed income stream to investors, becomes a noose around its neck during inflationary times. Inflation erodes the value of the fixed income that an investor receives. This is the reason bond prices stay depressed during times inflation is experienced. The longer a bond’s term, the more deleterious the impact of inflation, as it will compound over time.
There are some high-yield high-risk bonds that share some of their characteristics with equity instruments. They have greater flexibility in adjusting their cash flows and hence tend to perform better at such times.
Is inflation good or bad for stocks?
An analysis of S&P 500 portfolios found that annualized total return for a portfolio of stocks in the index from 1926 to 2015 was 10% which was higher than the inflation rate of 2.91% over the same period of time. Unfortunately, long term government bonds returned only 5.63%.
The key thing to remember is that past performance is no guarantee of future results, but stocks have historically provided higher returns than other asset classes. The research is based on data from Standard & Poors. It showed that stocks provide a longer-term potential for future returns that outpace inflation.
Unfortunately, Returns from stocks fluctuate a lot according to a lot of factors including inflation. In theory, a company that operates in an inflationary marketplace should feel inflationary pressure on its performance, which means its revenues and earnings should increase at the same rate as inflation. Hence, its performance should be inflation-neutral. The larger the company, the stronger the relationship with inflation.
Other relationships they found:
– Foreign stocks in developed markets tend to fall as inflation rises
– Returns from emerging market stocks tend to have a strong inverse relationship with inflation
Also knows as ‘real’ assets, such as commodities and property, they have been known to possess a strong positive correlation with inflation. As inflation rises, they rise even more.
Commodities are an important hedge against inflation. One reason is that certain commodities are a part of the basket that tracks inflation. Hence, commodities will partially be the reason for inflation being or not being there. Certain other commodities, like oil, have a strong relationship with and are often the cause of there being inflation.
The drawback, however, in investing in commodities remains their volatility as well as the fact that they do not produce income. Besides, over a long period of time, they have typically underperformed stocks and bonds.
However, property owners have flexibility in generating income. They have the ability to increase or decrease rentals to keep pace with inflation.
Your time horizon also affects your asset allocation
Many stocks involve a greater chance of short and sporadic fluctuations in value than other asset classes. The share price value can fall or rise its value based on news, economic trends or company problems. The important thing to consider is your time frame (short, medium and long), your income needs (retirement, paying for college, etc.), any other savings and assets you might have, and then build a portfolio with a diversified mix of stocks and other asset classes. If constructed properly, you will be able to manage the volatility in your investment portfolio as you plan for long-term investment objectives.
How to win against inflation
Investments need to be protected against inflationary volatility and value. The first thing investors should look at is diversification. This is one of the most basic, and sound, pieces of advice any investment professional will give you. Diversification of your portfolio can provide a cushion against the devaluation of the portfolio. Of course, this strategy does not provide and shield against losses in that particular stock, for any reason.
Solid Stocks: For the last 20 years growth stocks have dominated the stock market. We believe that rising inflation will cause money to leave growth and go into other investments. In addition, the cost of money will cause many growth companies to put expansion plans on hold, thus limiting the returns.
Real Estate: Real Estate has a great record of keeping up with inflation. Looking at the data, there can be a cause for concern of investing in companies that are planning on building new real estate. This is because there is a serious danger that the new buildings will come at a higher cost. Additional investors need to be very careful about REITs and BDCs that pay out high dividends as they could end out losing capital.
Precious Metal: Gold and precious metals have historically outperformed in rising inflation. That being said, they have not performed as well as stocks overall in the long term. It does provide a bit of insurance and padding in rising inflation environment.
TIPS (Treasury inflation-protected securities): As the name suggests, this is an investment that is designed to provide a hedge against inflation to investors. The return these Bonds offer is adjusted based on the CPI. These can be considered as inflation-neutral returns. As TIPS investors will know, while they may provide inflation-adjusted returns, their returns have not been known to be generous. The downside is that inflation could be much higher than TIPS. This will lead to capital depreciation.
Cryptocurrencies: There is not enough data to know the true effect of inflation on cryptocurrencies, but they were originally designed to protect against it. For those that understand them and the risk, this could be an asset class to consider.
With suitable investments and decisions, you can keep yourself, and your investments, protected against inflation. Like this article? Check out how to profit from inflation.