Summary: Inflation significantly influences investment strategies, impacting both asset values and returns. Key points from the blog include:
- Inflation’s history and recent spikes, affecting economic policies and investment perspectives.
- Measurement challenges and varying effects on different asset classes, questioning traditional CPI metrics.
- The nuanced impact of inflation on equities, fixed income investments, and real assets.
- The relationship between inflation, interest rates, and purchasing power, emphasizing the need for strategic portfolio adjustments.
- Strategies for inflation-proofing portfolios, suggesting diversification and specific asset inclusion to mitigate inflationary impacts.
Many investors and analysts continue to focus on the relentless climb of the stock market and proffering their two cents on its near-term direction. However, inflation needs to be considered as well.
Except for, perhaps, the baby boom generation, most people alive today have never experienced a sustained period of rising inflation. Since the 1980’s, the rate of inflation has been on a slow, albeit bumpy descent. Up until the early 2020s, it had been virtually nonexistent for many years.
Then, in April 2021, inflation appeared to turn on a dime, posting its highest year-over-year increase in decades. The media has been fixated on this surge, and economists have sounded the alarm over government policies that seem certain to unleash it further. Although inflation is down from its recent 9.1% peak in June 2022, rates remain significantly higher than those seen in the 2010s and decades previous.
Inflation, just like stock market performance and many other financial and economic factors, needs to be considered as part of a holistic investment strategy. How does inflation affect an investment’s return?
Keep reading to learn more about inflation and its influence on investments.
Do We Even Know How to Measure Inflation?
The signs would appear to be irrefutable. Spiking commodity prices surely must be the result of inflationary pressures that were predicted following the massive injection of money into the economy to stave off the pandemic-induced economic downturn.
Historically, it has been almost a direct cause and- effect scenario in which stimulative fiscal and monetary policies increase the inflation rate, so why would it be different this time?
This ambiguity stems from the lack of conformity in understanding what inflation is and how it manifests itself in the economy. And ever since the government decided to remove food and energy goods from the core CPI basket, even the measure of actual inflation is open to interpretation.
The Two Faces of Inflation
Our high school textbooks teach us that inflation results from too many dollars chasing too few goods. In other words, in a growing economy, increasing consumer spending pushes demand up to where it exceeds supply. In turn, that excessive demand drives up prices.
Modern inflation, if there is such a term, is more a creature of the money supply which, before the complete decoupling of the dollar from gold, wasn’t much of an issue. However, money supply manipulation goes way back to the creation of the Federal Reserve in the early 20th century.
Sticking with the fundamental principle of “too many dollars chasing too few goods,” a sharp increase in the money supply by the Fed can trigger inflation, but in a different way as we have seen just recently.
Where was Inflation Before 2021?
In its quixotic effort to stave off deflation, the Fed flooded the financial system with hundreds of billions of cheap (low-interest rate) dollars. Those dollars must go somewhere. Instead of finding their way into consumer prices, they found their way into the stock market.
There, they inflated asset prices resulting in the steepest stock market rally in history. The Fed was off target because it expected the dollars to find their way into the crashing real estate market via the banks. Instead, institutions and big investors snatched up the cheap dollars and poured them into stocks. The result would have been the same either way: Asset inflation.
Because inflation was funneled into asset prices, there was a delay in significant increases to consumer prices — although those increases have certainly come to fruition.
This allowed interest rates to remain low for a time. That, in and of itself, was a boon to stocks. Lower interest rates can increase the value of stocks because it makes discounted future cash flow more attractive to investors.
How Does Inflation Affect Investment Decisions?
While this explanation of recent inflation may make the case that it doesn’t necessarily have a negative impact on equities, there is plenty of evidence to show that it can.
The only real correlation found to exist between stocks and inflation is that stock valuations improve at the first signs of declining inflation and fall when it initially appears. This can be attributed to investor concerns over discounted future earnings. A company’s PE multiple (price to earnings) will have less value when future earnings lose their purchasing power.
How does inflation affect return on investment? Generally, stocks have performed well against inflation. Over the last 30 years, U.S. stock prices tend to rise when inflation accelerated, though that relationship is somewhat tenuous.
Producers can increase prices in response to the increased demand, at least to the point when demand begins to fall. This can drive earnings growth in companies that can increase production without increasing costs.
In periods of sustained inflation, the cost of production can also rise due to the increased cost of labor and materials. However, much of that increase can be passed on to consumers. In a normal economy, this type of inflation, especially if it is moderate and steady (which certainly hasn’t been the case for much of 2021-2023), can be good for stocks.
This correlation is stronger with larger companies with strong brands and competitive positions because they can increase prices. That means their revenues and earnings should increase at the same rate as inflation. Mid-sized companies have a weaker relationship with inflation, but it’s stronger than smaller companies.
Equities are productive assets that have on a total return basis over time provided a steady hedge against inflation. However, in times of sustained or severe inflation, deflation, or hyperinflation, all bets are off.
How does inflation affect saving and investing when it comes to other assets and investment options? Let’s take a closer look at some specifics related to inflation, investing, and saving.
Fixed Income Investments
Assets such as fixed-income investments with fixed, long-term cash flows generally don’t perform well in inflationary environments. That’s because inflation erodes the purchasing power of future cash flows over time. With each dollar being worth less due to inflation, the overall value of those future cash flows drops.
As a result, the price of fixed-income investments tends to decrease when the inflation rate increases. In that environment, bond yields rise, causing bond prices to decrease. However, it also creates the opportunity for fixed-income investors to purchase higher-yielding bonds, which can generate more income for their portfolios.
Investment-grade longer-term bonds are impacted more than shorter-term bonds due to the cumulative effect of eroding purchasing power for cash flows long into the future. Low-rated high-yield bonds are less affected because of their higher interest payouts.
One exception would be Treasury Inflation-Protected Securities (TIPS) issued by the U.S. government. The rate on TIPS is adjusted according to the CPI, but their value also fluctuates with changing interest rates.
Real Assets
Historically, commodities and real estate have had a mostly positive relationship with inflation. Commodities, including oil, industrial and precious metals, are natural inflation eaters. They rise almost in tandem with inflation.
However, historically, commodities have underperformed stocks and bonds. They tend to be more volatile than other asset classes because they don’t produce income.
Investment in rental properties is a sound hedge against inflation. Why? Because landlords can directly increase rent payments to keep pace with the rate of inflation. Rental property owners can’t completely price their rental units out of a market, of course, but they have a high degree of control when staying within those bounds.
Effect of Inflation on Interest Rates
Interest rates are especially sensitive to rising inflation. When inflation expectations increase, the Fed applies the brakes by increasing short-term borrowing rates.
This increases borrowing costs, leading to less money to spend on goods and services. In turn, this action ultimately tightens the money supply (meaning the money currently in circulation). The overarching objective is to reduce the demand that is fueling inflation.
The Fed has fought back against high inflation in recent years as this metric increased. Interest rates reached their highest point in about 20 years in 2023 and have held steady since. Although inflation has dropped off from its peak in mid 2022, rates are still noticeably higher than they were before this recent period of increased inflation.
Effect of Inflation on Purchasing Power
One thing we know for certain about the cause and effect of inflation is its impact on your purchasing power. When the inflation rate exceeds the growth of your money, it erodes at your future purchasing power. Your return-on-investment drops because inflation reduces the value of each dollar.
For periods of sustained, high inflation, the impact can lead to reduced purchasing power. It can also reduce the amount of income available in the future, negatively impacting your retirement. That’s why it’s essential to maintain an allocation to equities long into retirement.
Positive Effects of Inflation
Currently, the Fed is targeting an annual inflation rate of 2%. Its thinking is that allowing price levels to increase slowly will help businesses stay profitable while encouraging consumers not to wait for lower prices before making purchases. More importantly, moderate inflation can help to reduce the risk of deflation.
Rising prices resulting from mild inflation motivate consumers to buy now to avoid paying higher prices later. This results in a short-term increase in demand, leading to increased retail sales and the production of goods and hiring more workers to meet demand.
The net effect is a boost in economic growth. That is often a good thing when it comes to investments, although there are certainly exceptions.
The other reason why mild inflation can be a good thing is it reduces the risk of deflation—or falling prices—which can be more devastating than inflation. When prices fall, consumers hold off on purchases if they think prices will fall further.
That leads to reduced demand, causing businesses to reduce their inventory and factories to cut back on production. Those changes cause rising unemployment, wage deflation, and reduced consumer spending.
Without adjustments or corrective actions, demand decreases even more. Businesses reduce prices further, exacerbating deflation and creating a vicious cycle that is difficult to reverse.
How does inflation affect investments? While there are positives and negatives to consider based on the specific investments and assets involved, moderate, controlled inflation may be seen as better in the big picture as compared to deflation.
Impact of Inflation on Portfolio Decisions
Temporary spikes in inflation are not likely to have a significant, long-term impact on your portfolio. Long-haul investments, like those made with retirement in mind, can weather those shorter-term increases. A qualified fiduciary financial advisor can help you take this kind of temporary inflation into account and contextualize its impact on your investments.
A sustained inflationary environment could wreak havoc on your portfolio over time. Working with your financial advisor, you can fortify your portfolio against the negative impact of inflation. Addressing this kind of investment environment can be easier with support from a knowledgeable and experienced advisor.
Here are some steps to potentially consider to tame the effects of inflation on your portfolio.
- Diversify your portfolio with greater allocation to large-cap U.S. stocks, with an emphasis on high-quality companies with solid balance sheets.
- Consider adding real estate-based investments such as Real Estate Investment Trusts (REITs).
- For the fixed income portion of your portfolio, consider adding Treasury Inflation-Protected Securities (TIPS). You can also invest in a TIPS ETF.
It helps to remember that you can’t control when or if inflation will strike again — not even an organization with all the resources and influence of the Federal Reserve can completely control inflation. However, you can take actions that will protect your portfolio against its effects. Changes to your portfolio are entirely within your control.
We invite you to meet with an advisor from Dechtman Wealth Management for a free, no-obligation portfolio review.
