In recent years, many successful investment strategies have been based around the assumption of continued low and stable inflation. With the global economy recovering strongly from the COVID-19 pandemic, inflation risk has increased.
In this article, we look at how rising inflation could affect the economy and investment markets.
- Inflation is a sustained rise in the price of goods and services in an economy
- Rising inflation can harm the economy by creating business and investor uncertainty
- Rising inflation can also place upward pressure on interest rates and downward pressure on some asset prices
- To guard against these risks, it is important to make sure your portfolio is well diversified
What is inflation?
Inflation is a sustained rise in the price of goods and services in an economy.
There are two widely used indicators of inflation:
- the consumer price index (CPI)
- the producer price index (PPI).
The CPI measures the price of a basket of goods and services typically purchased by households, and so reflects price pressures faced by consumers.
The PPI measures the price of a basket of goods and services typically purchased by producers, and so reflects cost pressures faced by business.
Changes in these price measures is referred to as inflation. So, for example, if the price of the basket of goods and services as measured by the CPI increases by 2.5% over one year, we say annual consumer inflation is running at 2.5%.
The chart below shows annual Australian consumer price inflation over the three decades to the end of the December quarter 2021.
Why does inflation matter?
Inflation matters for several reasons.
For starters, rising inflation can hurt economic growth to the extent it results in a rise in business and consumer uncertainty. Someone somewhere must pay for higher higher prices within the economy, which can hurt living standards where incomes don’t rise to compensate. Uncertainty as to the degree of price pressures to be faced, and the degree to which these can be ‘passed on’ to others through compensating increases in wages or prices, can cause a drop in consumer spending and business investment.
For example, higher commodity prices mean manufacturers have to pay more for the materials they use to produce their goods, which means they either have to increase the prices they charge for the goods they produce, or they suffer from tighter profit margins.
Rising energy prices are also a challenge for some companies, as they have to pay more for the power they use, and the cost of transporting goods increases. These increases typically flow through to the prices manufacturers charge.
Inflation can also mean an increase in cost of living pressures for consumers. Higher inflation means consumers need to spend more to get the same amount of goods or services. Unless wages also rise in line with inflation, this can result in a lower standard of living.
Rising inflation can mean rising interest rates
Higher rates of inflation can also place upward pressure on interest rates, as lenders usually want higher compensation to part with their money given that it will be able to buy fewer goods and services when returned in the future. In turn, higher interest rates can place downward pressure on the value of some investments, such as more speculative high growth companies and even those offering long-term income streams such as property and infrastructure assets.
If inflation gets out of hand, moreover, the economic impact can be even more damaging as it can result in central banks tightening credit conditions to slow economic growth and lower pricing pressures.
It should be noted that a low and stable level of inflation is generally regarded as a good thing. A moderate level of inflation is seen as a sign of a growing economy. In Australia, the RBA Governor and the Treasurer have agreed that the appropriate target for monetary policy in Australia is to achieve an inflation rate of 2–3%, on average, over time1.
As with most things in life, it’s a question of balance: a little inflation is OK, but too much can be damaging.
How does inflation affect investors?
Inflation eats up the value of money for everyone – not just investors.
Returns can be thought of in ‘nominal’ or ‘real’ terms. The nominal return is the actual rate of return in percentage terms. The real rate of return is the nominal return less the inflation rate.
For example, if you invest in a term deposit paying 4% p.a., and inflation is 2% p.a., your real return is 2% p.a.
A higher inflation rate means you have to earn a higher rate of return simply to break even in real terms.
How are share investors affected?
While modestly rising inflation generally is seen as a positive for the broad sharemarket, as it is consistent with an economy growing at a sustainable pace, inflation above a certain level, or unexpected jumps in inflation, can be a negative – although the effect may vary for different sectors, and for different investing styles.
Higher inflation is usually seen as a negative for stocks because it typically results in:
- increased borrowing costs
- higher costs of materials and labour
- reduced expectations of earnings growth.
Taken together, these variables generally put downward pressure on stock prices.
Are all stocks affected the same?
The answer to this question is – ‘No’. There are some sectors that have the potential to outperform in inflationary environments.
Gold is widely regarded as a ‘safe haven’ in inflationary environments, given that it is seen as a ‘store of value’, so an exposure to gold bullion or gold producers may have the potential to outperform.
People need to eat, regardless of whether inflation is rising or falling. Investors can consider exposures to agricultural commodities and food producers in an inflationary environment.
If rising inflation is accompanied by increases in the prices of commodities such as iron ore, this will have a negative impact on the purchasers of those commodities – but is likely to benefit commodity producers such as iron ore miners. Similarly, if there is an associated increase in the price of oil, an exposure to energy producers may provide defensive benefits.
Growth vs. value stocks
Inflation has generally tended to affect growth stocks more than value stocks.
A common method used to value stocks is the discounted cash flow (DCF) method. Essentially, DCF values an investment based on its future cash flows. It involves calculating the present value of expected future cash flows, by applying a ‘discount rate’ to those future cash flows, to arrive at a valuation. The discount rate is dependent on interest rates – the higher the rate, the lower the present value of future cash flows, and therefore the lower the valuation attributed to the investment.
The other relevant point is that the further into the future a cashflow occurs, the lower the present value of that cash flow will be.
Many growth stocks have relatively low cash flows now, but are expected to generate significant flows in the future, while many value stocks have strong cash flows now, but are expected to grow at a slower pace, or even decline.
Increases in inflation and interest rates are therefore likely to have a higher impact on growth stocks than on value stocks, as the cashflows their valuations are based on will be discounted more.
Fixed income investors
Rising yields (interest rates) are bad for fixed income investments that pay a fixed rate of interest, such as bonds, for two reasons.
Firstly, there is an inverse relationship between a bond’s price and its yield – as interest rates increase, bonds fall in value, so bond holders can face capital losses.
Secondly, the income stream from fixed rate bonds remains the same until maturity. As inflation rises, the purchasing power of the interest payments declines.
Investments that pay a floating rate of return are likely to be better off in an inflationary environment, as the interest rate they pay is adjusted periodically to reflect market rates. If interest rates rise, the interest paid by the investment should also increase at the next reset date. This applies to investments such as hybrid securities, as well as funds (including exchange traded products available on the ASX) that provide exposure to such hybrids.
Inflation is generally regarded as damaging to holders of cash and cash equivalents, since the value of cash will not keep up with the increased price of goods and services.
An inflationary environment can present challenges for investors. It is important to make sure your portfolio is well diversified, and provides exposure to investments that have the potential to provide some defence against rising inflation.
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