What is “How Does Inflation Affect Investments”?
As inflation measures how quickly the prices of goods and services are rising, many investors carefully assess how their portfolios perform with respect to inflation. Inflation can affect the value of future returns and is, therefore, a critical consideration when making investment decisions. For example, increased inflation would result in some asset classes that are exposed to fixed, long-term cash flows underperforming since the purchasing power of those future cash flows declines over time. On the other hand, assets with more flexible cash flows might perform better and offer protection against inflation.
The Consumer Price Index (or CPI) is the most widely used indicator of inflation. Most developed countries target an inflation rate of around 2% per annum. Central banks have the power to control inflation by setting interest rates – should prices begin to rise faster, they will respond by increasing the base rates.
Inflation affects different asset classes in different ways. For example, those with fixed long-term cash flows will see their purchasing power eroded, whereas investments with more adjustable cash flows could outperform. Cash and cash equivalent products and fixed income are the usual casualties of higher inflation. Commodities, tangible assets such as property or infrastructure, and some equities have the potential to perform well in an inflationary climate.
Key Learning Points
- Inflation measures how quickly the prices of goods and services are rising
- The Consumer Price Index is the most widely used indicator for inflation, and central banks are mandated to keep inflation under control
- Inflation affects different asset classes in different ways
Inflation and Cash Savings
Inflation is the biggest threat to savings accounts that are tied to an average interest rate. Saving accounts are considered a relatively safe asset class since the risk of financial loss in absolute terms is pretty much non-existent. However, if the returns provided cannot keep up with the rising price levels, then purchasing power declines.
Inflation and Bonds
Fixed-income securities such as bonds are also on the lower end of the risk scale since they offer a stable income stream in the form of coupon payments plus the principal (initial investment) at maturity. Nevertheless, typically bonds offer the same interest rate until maturity, which means that purchasing power of the coupon payments declines as inflation rises. Therefore, bond prices tend to fall when inflation increases.
Inflation and Equities
Equities are one of the possible safe havens from rising prices as companies’ earnings should increase at a similar rate as inflation. In theory, that would drive share prices up along with the general consumer and producer goods. However, not all stocks tend to perform well during periods of high inflation. Businesses with larger market capitalization typically achieve higher returns than their smaller peers as their market presence is more established and revenue streams are more diversified. Also, specific sectors such as commodities often experience higher returns during periods of increased inflation. On the other hand, growth stocks that expect most of their cash flows to arrive in the future, such as tech stocks, may underperform in periods of high inflation.
Inflation and Real Assets
Gold is traditionally considered to be the best safe haven from inflation. Real assets such as property and infrastructure correlate positively with inflation and can be another safe refuge from inflation. Real estate owners can increase the rent when prices rise, which can feed into profits and investor returns, respectively. Energy-related commodities such as oil also show a strong positive correlation with inflation.