Investing in times of inflation can be tricky. Whether cash, bonds, stocks or other asset classes, investments have distinct risk/return profiles. Inflation risk can affect them all.
Unsurprisingly, Americans are nervous amid today’s sky-high inflation. A May survey by BlackRock Fundamental Equities revealed that 62% of investors see inflation as the biggest threat to the US stock market over the next six months. What’s an investor to do?
But first, what is inflation?
Inflation is the rise in price of goods and services over time. If prices rise and income remains fixed, the purchasing power of money decreases. Moderate inflation is generally good news, as it can indicate a growing economy, with job growth and rising wages. However, if inflation spikes in a short period, consumers’ money quickly loses value. As customers tighten their purse strings, corporate profits may suffer due to weak sales and rising costs.
Understanding inflation risk: For investors, “inflation risk” is the risk that inflation will erode an investment’s returns due to a decline in purchasing power. Returns on investment can be measured in two ways:
- The nominal rate of return is the return on your investment without taking inflation into account.
- The real rate of return takes inflation into account. It is the return on your investment minus the rate of inflation that gives you the purchasing power of your investment.
In times of inflation, your real rate of return matters most.
The current state of affairs
Last June, the annual inflation rate in the United States reached 9.1%, the highest level since 1981. This rise in inflation meant that a carton of eggs that cost $1.60 in 2017 now had a price of $2.71. Indeed, the price of basic necessities such as food, vehicles and housing had all risen, leaving less money for the “extras” that were affordable five years ago. In July, inflation eased somewhat to 8.5% year-over-year, in part because gasoline prices fell significantly.
Article Price in 2017 Price in June 2022
Bread $1.35/bread $1.69/bread
Eggs $1.60/box $2.71/box
Chicken $1.42/lb $1.83/lb
Electricity $0.13/kWh $0.16/kWh
Cause and effect: The seemingly endless COVID-19 pandemic and recovery, an unpredictable economic lockdown/reopening cycle, and fractured supply chains have created an environment of low supply and pent-up demand. With nowhere to go and nothing to do for much of the pandemic, and with the help of government aid programs, consumer wallets swelled, creating a robust spending cycle and driving up prices. The ongoing war in Ukraine and the rising cost of labor and oil have further exacerbated inflation.
To calm inflation, the US Federal Reserve has raised interest rates to reduce demand, and further rate hikes are expected this year. It looks like we are entering a full-scale war on inflation.
As a result, the S&P 500 has fallen more than 10% this year (as of mid-August), following a strong stock market performance in 2021. Americans who have invested heavily, expecting weak inflation and interest rates of the past two years continues , are now scratching their heads.
Implications for the Bond Investor
For most investors, bonds tend to be the most vulnerable to inflation risk because their payouts are usually based on fixed interest rates. As inflation rises, it eats away at the purchasing power of a bond payment. For example, if an investor bought a 30-year bond that pays an interest rate of 4%, but inflation is currently around 8.5% (in July), that bondholder loses a significant purchasing power year after year.
But rising inflation is not bad news for all bonds. Floating rate investments can cushion the blow because their payouts are based on an index that changes with inflation rates, such as the prime rate.
Inflation-linked bonds, such as Treasury Inflation Protected Securities (TIPS) and I’m reading, are part of these investments. Returns are tied to the cost of consumer goods, which helps protect purchasing power.
Convertible bonds can also hedge against inflation because they sometimes trade like stocks. As stock prices are affected by fluctuations in inflation, these bonds can preserve purchasing power to some extent.
Implications for the equity investor
Unlike the typical bondholder, many equity investors may have less reason to panic. History teaches us that high inflation is associated with lower returns on stocks, but not all stocks are created equal. Value stocks can perform well as long as inflation doesn’t get out of hand – above 10%, a rare and unexpected event during this period. Because much of their expected cash flows are loaded upfront, value stocks can return capital to shareholders faster than growth stocks, giving them an advantage in cycles of moderate to high inflation.
However, growth stocks are loaded in the back-end. These longer-dated assets promise cash flow far into the future and fare better in an environment of modest inflation and low interest rates.
However, growth stocks are not to be neglected. Our current environment of high inflation and high interest rates has dampened the performance of growth stocks this year, but many companies continue to innovate and move forward. Therefore, growth stocks could still be a solid long-term investment.
Stock performance also varies by sector. Cyclical stocks such as financials, energy and resource companies tend to shine when the economy is booming or recovering. On the other hand, stocks of energy, utilities and consumer goods often crash during times of inflation.
Many analysts do not expect high inflation to last for an extended period. However, consumers are not convinced: median one-year inflation expectations were 6.2% in July, although this is down from the 6.8% recorded in June. Inflated inflation expectations can end up being a self-fulfilling prophecy. Naturally, fears of a recession in 2023 abound.
The truth is that COVID-19 has made it exceptionally difficult to anticipate the direction the economy is taking. Today’s economists, policymakers, and analysts have no experience in assessing the financial fallout of a once-in-a-lifetime pandemic, and many have been consistently wrong in their predictions.
What’s an investor to do?
Nobody knows what’s coming, which is cold comfort for the average investor. But even in these uncertain times, proven investment principles hold true.
First, it is always best to manage risk, whether from inflation or other sources, through a well-diversified portfolio – a portfolio made up of assets that are diversified across sectors, markets, currencies and even country.
Second, it is important not to panic. Despite current market volatility, investing and inflation are not mutually exclusive. A cautious and measured investment approach that covers a variety of scenarios is essential.
Once a clearer picture of the post-pandemic investment regime emerges, investors can regroup and recalibrate. In the meantime, they can take comfort: if history is any indication, inflation tends to be a temporary problem with a manageable impact on long-term investment goals.
— Anise Chopra, CPA (Canada), CA, CFA, EEE, is Managing Director of Portfolio Management Corporation in Toronto. He is a member of the AICPA Personal Financial Planning Executive Committee. To comment on this article or suggest an idea for another article, contact Dave Strausfeld at [email protected].