Inflation explained: is it the right time to invest?
In its latest world economic outlook, the International Monetary Fund has revised downwards its global growth forecast for 2022 from 4.4% to 3.6%. Furthermore, it stated that inflation is expected to be worse in developing nations, with an estimated average of 8.7% compared to developed countries, where a rate of 5.7% is anticipated. Inflation is becoming a growing concern around the world, with food and energy prices hitting record highs, is it the right time to invest?
Latest figures show that energy and food prices rose by respectively 30.3% and 9.4% in April, the most over 40 years. Despite the slowdown in April, which shows that inflation has likely peaked, inflation may not return to levels seen before the pandemic anytime soon and will probably stay over the Fed’s 2% objective for a long time given supply disruptions and high energy and food prices.
While the overall rise in prices between 2020 and 2021 related to COVID-19 lockdowns, the recent inflation was mostly driven by a surge in energy and food prices, especially since the outbreak of the war in Ukraine on 24 February 2022. Global inflation rate in March 2022 reached 9.2%, more than doubling the rate of 3.7% recorded over the same period last year. Inflationary pressures have risen significantly since the beginning of 2022, owing to prolonged and additional disruptions in supply chains, as well as negative supply shocks caused by Russia’s invasion of Ukraine and the associated sanctions regime. This conflict is expected to have a greater impact on oil and gas prices this year, while food prices may be affected for a longer time.
Understanding inflation
Inflation is the gradual rise in prices over a specified period of time across the entire economy. The rate of inflation is an essential economic concept since it shows the rate at which an investment’s real value erodes over time, as well as the loss in spending or purchasing power. Inflation also tells investors how much return (in percentage terms) they require on their assets to maintain their current level of life.
In contrast, deflation is a decrease in the overall level of prices in the economy. When consumers anticipate further price cuts, they frequently reduce their spending. Reduced consumer spending during deflationary periods generally has a negative impact on the economy (e.g., high unemployment, recession, etc.). During the Great Depression (between 1929 and 1933), price deflation happened in nearly every industrialized country in the world.
Disinflation, as opposed to inflation or deflation, may be defined as a temporary slowing of the rate of price inflation and generally used to describe situations where inflation has decreased marginally over the short term. For example, it can be brought on by a recession or following the tightening of a central bank’s monetary policy. Between 2011 and 2015, there was a deflationary period in the United Kingdom when its inflation rate went down from 5% to 0%.
Stagflation is another term that is worth knowing. It is an economic event where inflation remains high, economic growth is slowing, and unemployment remains persistently high. Stagflation occurred in the 1970s, time when the price of oil tripled.
Finally, reflation is a macroeconomic policy aimed at increasing output, stimulating expenditure, and reducing the impacts of deflation, which typically happens following a period of economic instability or a recession. Lowering interest rates, lowering taxes, and printing money are some good examples of this type of policy. One great example of reflation occurred during the Great Recession of 2007-2009 where the Federal Reserve increased its bond buying programme to stimulate economic activity and increase the U.S. money supply.
There are two readily watched economic indicators which both measure changes in price of goods and services that track inflation:
- The Consumer Price Index (CPI), which measures the percentage change in the price of a basket of goods and services consumed by households, is the most well-known indicator of inflation, and
- The Producer Price Index (PPI) looks instead at the percentage change in the price of a basket of goods and services generally purchased by producers, thus reflecting cost pressures faced by business.
Types of inflation
There are 3 types of inflation:
- Demand-pull inflation: This occurs when demand for goods or services is higher when compared to the production capacity, i.e., demand is greater than current supply resulting in a price appreciation.
- Cost-push inflation: This happens when the cost of production increases. Rise in prices of the inputs like labour or raw materials increases the price of the product. It is determined by supply-side factors, such as higher wages and higher oil prices.
- Built-in inflation: Also known as “wage-price spiral”, it occurs when workers ask for higher wages to keep pace with the increased cost of living. Built-in inflation is basically a vicious cycle of rising costs and increasing wages responding to one another.
Causes of Inflation
There are several causes for inflation, a loose monetary policy like low-interest rates by central banks can often lead to high inflation. Quantitative easing is another phenomenon that can trigger inflation, here the central banks buy long-term securities from the open market with a view to inject money into the economy thereby fostering business. Lastly, natural disasters, pandemics, and growing costs can all disrupt supply chains, hence reducing supply levels. Demand shocks, such as a stock market rally or expansionary economic policies, on the other hand, can temporarily enhance demand and economic growth.
With inflation on the rise, investing in the stock market has become more important than ever. Historically, investing in equities has been the best way to stay ahead of inflation. As a guidance, the annualized return of the S&P 500 Index over the past 10 years is 14.7%, much higher than the 8.3% year-over-year inflation seen in April. For the 12-month ending April 2022, the US Consumer Price Index was up 8.3% according to the Bureau of Labour Statistics.
Prices are rising significantly worldwide in 2022 due to strong customer demand and labor after the Covid-19 pandemic as well as supply chain disruptions, putting a greater strain on consumer budgets than seen over the past 40 years. One important factor to stay ahead of inflation is to find the right strategies to diversify across different investment vehicles. During inflation, it becomes more important to invest your cash as one dollar today will buy less value of goods or services than ten years ago, making cash losing its purchasing power during inflationary periods. Hence, investing your long-term savings in the financial market might be a good option to earn a return thus minimizing the effect of inflation, or maybe reaping a return that keeps up with or beats the inflation rate.
How does inflation affect investors?
During inflation, money loses its value, and this affects everyone, not only investors.
Returns can be categorized as either nominal or real. In investment, the nominal rate of return in percentage terms is known as the actual return. The real return is obtained by subtracting the inflation rate from the nominal return.
Just as an illustration, if you invest in a 5% p.a. term deposit and inflation rate is 2% p.a., your real return will be 3% p.a.
To break even in real terms, an investor will need to earn a higher rate of return when inflation rises.
How can investors be protected against inflation?
Inflationary pressures can be very harmful to the economy by causing uncertainty among businesses and investors. Rising inflation can put upward pressure on interest rates while also putting downward pressure on some asset values. Inflation can have a significant influence on your portfolio over time. To be protected against these risks, it is vital to ensure that your portfolio is well-diversified. Here, talking to a financial expert would make sense and together with the investor, the most appropriate approach to protect the latter’s investments can be established.
Normally, assets with fixed, long-term cash flows have the tendency to perform weakly during inflationary periods, as the purchasing power of those future cash flows drops over time. In opposition, commodities and assets with variable cash flows like rental income from properties usually perform better in times of escalating inflation.
The following table summarizes how investors could adjust their allocations to changing growth and inflation dynamics:
The most popular hedging strategies to be protected against inflation:
- Commodities have shown to be a reliable approach to hedge against rising inflation in the past. Oil and other energy-related commodities have a particularly strong link to inflation. When inflation accelerates, industrial and precious metals prices tend to rise as well. However, commodities have a significant disadvantage as they are more volatile than other asset types, offer no income, and have historically underperforming stocks and bonds over longer periods of time.
- Many investors also prefer to hold productive assets e.g., value stocks or real estate that generate dividends. The past 10 years through January 2022 saw an outperformance of large cap growth stocks versus value stocks. During periods of inflation, value stocks perform better than growth stocks given that the former have strong cash flows. If a long-term inflationary environment is expected, then allocating a portion of a portfolio to value stocks and value funds might be a good choice.
- Real Estate/Real estate investment trusts (REITS): Equity REITs always have the tendency to mitigate the effect of soaring inflation as REITs possess real estate assets and can increase rent payments and property prices when inflation rises. Accordingly, this will flow through to profits as well as distribution to investors. Using a fixed rate mortgage to finance the purchase of a house may also be considered as a good hedge against inflation, especially when rates are at historic lows. Moreover, owning a home offers a potential rise in its value over the long term.
- Treasury inflation protected securities (TIPS): TIPS provides interest rate twice a year to investors, with the principal adjusted in accordance with the Consumer Price Index. Hence, the performance of TIPS gives a more reliable performance compared to other types of bonds or asset classes. Though, returns on TIPS are relatively low.
- Given that gold is usually viewed as a ‘safe haven’ in inflationary conditions due to its status as a ‘store of value,’ an investment in gold bullion or gold producers could outperform other asset classes. However, it should be noted that gold does not provide compounding returns and hence its price tends to stay relatively flat.
- Invest in low-capital-requirement firms. During inflationary periods, businesses with minimal capital requirements that can sustain their profitability should perform better than those that must invest more money at ever-increasing prices merely to stay afloat.
- Look for companies that can raise prices during periods of greater inflation; if a company can raise prices during periods of higher inflation, it has a significant advantage since it can offset its own rising costs.
- Avoid traditional bonds; with interest rates currently around historic lows, bond investors may be severely harmed in an inflationary scenario. Depending on their specific investment goals and objectives, investors should be very careful by not deviating from them. For instance, it is not recommended to be overweight on TIPS if an investor is looking for capital appreciation. Another example is that someone should not be buying long-term growth stocks when that person is planning for an imminent retirement.
Challenging times are ahead for both central banks and investors. Slowing growth and rising prices will have to be addressed without triggering stagflation and recession and investors should use an active approach to protect their portfolios. It is quite hard to say whether the current surge in inflation will stay or likely to start weakening. During these periods, it is particularly important not to overreact and ensure that investment decisions remain aligned with your objectives. The value of diversification becomes clearer in times of volatility. It is essential, above all, to keep your long-term objectives in mind, to consult your investment adviser and to avoid behavioral biases.
