Inflation: what rising prices mean for your investments

16 August 2022
what inflation means for your investments

Introduction

As inflation rises, the purchasing power of your money declines. This means that it takes more money to buy the same goods or services. Over time, it can eat away at the value of your investments, leaving you with less buying power than when you started.

As a general rule (and at the very least) investors need to “beat” the inflation rate, and that of course becomes harder as the rate grows. Otherwise, you will find that, despite the number in your bank account being higher, you actually can purchase fewer goods, i.e. you are poorer, not richer.
One way to combat the effects of inflation on your wealth is to invest in assets that have the potential to appreciate in value over time, with prices moving in line with inflation, such as real estate or commodities. Another is to invest in companies that are able to raise prices in line with inflation, such as utility companies, or strong companies with oligopolistic pricing power .

Whatever strategy you choose, it’s important to realize that inflation is just one of many factors to consider when making investment decisions so don’t let it derail your overall strategy. But by being aware of the risks and taking steps to protect your portfolio, you can help ensure that your investment dollars hold their value over time.

Inflation does not impact all assets equally

There are a few types of investments that generally do well: 

Real estate: home values tend to go up over time, especially when inflation is high. As inflation rises, so does the cost of building materials and land, which drives up the price of homes. Also, since real estate is well known as an inflation hedge, the demand may grow during inflationary periods for this very reason, further increasing home values. Lastly, real estate returns (i.e. rental income) also move in line with inflation, leaving investors quite protected.

Commodities: Commodities are things like gold, oil, and wheat—basically, anything that’s considered a raw material. Gold is a classic inflation hedge. When inflation is high, people often turn to gold as a way to preserve their purchasing power, which in turn means that inflation and gold price are generally positively correlated.

Inflation-protected securities: These securities are designed to keep pace with inflation. An example is TIPS (Treasury Inflation-Protected Securities): TIPS are bonds issued by the U.S. government that offer protection against inflation. The principal and interest payments on these bonds increase along with the Consumer Price Index (CPI), so you can be sure that your purchasing power will not be eroded by inflation.

Selected stocks or ETFs: some sectors and industries are able to adjust the prices of their products and services more than others.

What about bonds? 
Bonds are fixed-rate investments. If inflation is increasing, the return on a bond is reduced in real terms, i.e. payments on those bonds don’t increase at the same rate as inflation. Equally, the capital invested in a bond is returned at maturity but that amount is fixed in nominal terms (and therefore lower in real terms).

Finally, what about the new kid on the block: crypto?
For crypto, there is not yet a definite conclusion. If there’s one crypto asset touted to be a good inflation hedge, that’s definitely Bitcoin. Why? Because inflation is mostly a monetary phenomenon created by an excessive supply of money in the system. The supply of Bitcoin is fixed forever at 21 million Bitcoins, therefore it might act as a permanent store of value immune to currency debasement.

Having said that, this still remains to be proven. The long-term history of Bitcoin from a value of 0 to today’s might indicate the hedge to be real but the performance against the high inflation period of 2022 has been very  poor so far. So the jury is still out on whether Bitcoin will become an inflation hedge or even an international reserve currency.

Has inflation peaked?
Data released on 10 August 2022 showed U.S. consumer prices were unchanged in July, month on month, effectively reducing the US consumer price index in July from 9.1% to 8.5 per cent, year on year. The markets’ initial reaction to the news has been euphoric, and many pundits have suggested inflation has peaked. But has it? To try and answer this question, the first step is to realize that every month, when the annual CPI is updated, a new monthly value (zero for July) is added, while an old monthly value is dropped. This means that, for inflation to have peaked, the coming months will need to record monthly values that are lower than those that get dropped in the calculation. And these values are already known and are – unfortunately – very low. This means that even if every single monthly value from August 22 until the end of the year is zero as it was in July, we will still end the year with an annual CPI of over 6%. And in the more likely (yet still optimistic) case that the next few months record “normal” values (i.e. 3%), at the end of the year the annual CPI will have decreased from 8.5% to 7.6%, not exactly a huge difference.
The conclusion is that inflation may have peaked, but it will anyway remain at or near historically-high levels for many more months to come.

Main effects of inflation

Rising prices are responsible for  several repercussions in everybody’s life.

1. As prices rise, consumers’ purchasing power decreases. This can be a major problem for low- and middle-income earners, as they may not be able to keep up with the rising costs of living.

2. Wages don’t necessarily  keep up with inflation: this can leave workers feeling like they’re stuck in a low-paying job or struggling to make ends meet.

3. Interest rates rise: when inflation is high, monetary authorities raise rates to turn it around. This can make it more difficult to afford loans and other forms of debt. It can also make saving for retirement more difficult, as your savings will be worth less in real terms.

4. Investments lose value: inflation causes investments to lose value in real terms. Investments’ value might be going up but it’s not enough if prices rise faster

But high inflation also brings advantages. If inflation reduces the real value of your investments, it equally reduces the real value of your liabilities. In other words, the real value (and cost) of  your debts is essentially eroded by inflation.
During periods of high inflation, those with long-term debt (e.g. mortgages) and inflation-defensive assets (e.g. real estate) can benefit while those with high cash savings lose ground.

Conclusion

For several decades investors have not been concerned much with inflation as prices were rising slowly and predictably. But in the past year or so things have changed quite dramatically. High inflation has become one more parameter investors have to consider when defining their strategies.  
Thankfully, investment options that fare well in such an environment do exist and are easily available. Investing for the long-term needs to take into account inflation and you should always keep a clear view on the real performance; any asset with an MWR below 7-9% lost value in the past year.

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