Inflation and Investment: What Investors Need To Know

Reflection Series - Inflation and your portfolio: Part I

Understanding the mechanics of inflation is essential for investing, as inflation can reduce the value of investment returns. After several years of relative calm, inflation is expected to reach its highest level in four decades. Investors need to be aware of the causes of inflation, how it affects their portfolios, and what to do when the investment landscape changes so that they can protect their portfolios, and maintain and/or increase their returns.

Inflation is a sustained increase in the general price level that affects all aspects of the economy, from consumer spending, business investment and employment rates to government programmes, tax policies and interest rates. Moderate inflation is associated with economic growth, while high inflation can signal an overheated economy. When inflation sets in, money loses its purchasing power because prices rise. Inflation is measured by the percentage change in the consumer price index (CPI), which measures the cost of a basket of basic goods and services. Using the monetary policy instruments at their disposal, including the power to change interest rates, central banks seek to keep inflation (or the increase in the cost of that basket) within a range of variations defined annually. However, this is a double-edged sword, as prolonged episodes of high inflation are often the result of a "loose" monetary policy, which may include low-interest rates.



What drives inflation?

There are many causes of inflation. Economists do not always agree on the causes of inflation, but in general, they group them into two different categories: cost-push and demand-pull inflation.

Rising commodity prices - such as since the start of the Ukraine conflict in February 2022 - are an example of cost-push inflation, because when commodity prices rise, the costs of basic goods and services generally rise.

Demand-pull inflation occurs when the aggregate demand of an economy increases too rapidly. Demand shocks, such as a stock market rally or expansionary global economic policy (such as a central bank lowering its key interest rate or a government increasing spending) can temporarily boost demand levels and overall economic growth. Demand outstrips supply, leading to higher prices.

Another common phenomenon that can trigger demand-pull inflation is the monetary policy of "quantitative easing". In this monetary policy strategy, central banks buy long-term securities (such as government bonds) on the open market. In doing so, they take assets out of circulation and inject money into the economy to encourage purchases, lending and investment. Quantitative easing has been the main tactic used by central banks around the world throughout the COVID-19 pandemic to support demand and the economy in general.

How does inflation relate to interest rates?

In theory, inflation and interest rates move in an "inverse" relationship. As interest rates have never been so low since the beginning of the pandemic, this has created a breeding ground for inflation. When inflation is rising quickly, central banks may respond by raising interest rates.

In early 2022, as the economy and labour market fully recovered from the effects of the pandemic, central banks began to raise policy rates to manage inflationary pressures. The main objective is to increase the cost of borrowing, making loans more expensive (and harder to repay) for businesses and consumers. Overall, less borrowing and more investing reduce the supply of money in circulation, which cools economic activity and naturally reduces inflation.


What do rising inflation and interest rate mean for your portfolio?

Inflation risk can impact all types of assets, but Inflation can be particularly challenging for investors with little exposure to stocks and higher exposure to cash, bonds and other fixed-income securities. Continued higher inflation would have far-reaching implications for portfolio diversification as stock-bond correlations tend to rise when inflation is higher. So bonds may provide fewer diversification benefits in that kind of environment, although they still have merit as core portfolio holdings.


Bonds are particularly sensitive to interest-rate changes, as many pay a fixed rate of interest. If the rate of inflation rises, the purchasing power of the bond's future (fixed) coupon income, reduces the present value of its future fixed cash flows. When interest rates rise, the market price of the bonds held will immediately fall, as new bond issues will offer investors higher and more attractive interest rate payments to encourage them to buy. In general, the higher the duration, the more a bond’s price will decline as interest rates rise. Therefore, during a period of rising rates, it is beneficial to hold bonds which exhibit lower duration, to reduce exposure to interest-rate risk.


Stocks, on the other hand, can offer some protection against inflation, depending on the type of company. Some companies may increase the price of their goods or services when inflation rises, in order to maintain their profit margins. However, inflation can have a negative impact on companies as they absorb the higher prices and the slowdown in sales can impact their revenues and profits.

Rising interest rates can have a negative impact on the stock market because when rate increases make borrowing more expensive, the cost of doing business increases for companies. Over time, higher costs and reduced business activity could result in lower revenues and net profits for companies, which could affect their growth rate and share value.

Inflation Impact on select asset classes 1990-2020


What may inflation mean for investors?

In an environment of rising inflation and constantly changing investment conditions, investors may consider investing in inflation hedging assets, while keeping in mind the fundamental investment principles of maintaining a well-diversified portfolio, rebalancing regularly and ensuring that investments remain in line with long-term objectives.



 

Disclaimer: This article is provided for information purposes only and does not constitute an invitation to invest. Please seek advice from your investment advisor before investing.


Continued in Part 2: -Protecting Your Investments Against Rising Inflation