We’ve all noticed that the cost of everyday goods and services has been rising more rapidly than at any time in the last twenty-five years. The conflict in Eastern Europe has disrupted supply chains and energy provision, leading to an increase in the price of food, fuel and other services. The rate of such price rises is known as inflation.
What is inflation?
Inflation is a way of measuring the change in price of everyday goods and services, from food and fuel to cinema tickets and haircuts. Prices usually increase over time, so the cost of your weekly shop tends to go up over the year. If it’s 10% more expensive than it was 12 months ago, then that is the approximate rate of inflation in food. In the UK and eurozone, central banks aim to keep inflation below 2% so that prices don’t rise too fast and make goods and services unaffordable for those on the lowest incomes.
High inflation can have negative consequences for exactly this reason, but inflation isn’t always a bad thing. If people expect inflation to rise in the near future, they may buy more goods and services. This stimulates economic activity and drives growth in most sectors. Inflation can also lead to higher wages, job creation and the reduction of debt burdens in the short term. But, in the longer term, inflation can have a negative impact on your purchasing power.
How inflation impacts your purchasing power
On small purchases, you may not notice the effects of inflation but, if you’re saving for a house valued at a million dollars and inflation is running at 5%, you could need an extra $50,000 to have the same purchasing power. Even smaller purchases like cars or expensive tech can see their prices change dramatically over a short time period.
Knowing your risk tolerance is a fundamental building block of long-term investment success. Setting personal goals will go a long way towards determining the level of risk that you are willing – and able – to take. In turn, your risk tolerance will affect the type of assets you own and, ultimately, the shape of your portfolio.
Take our retired investor, who might have spent their entire life building a business. The desire to preserve their wealth likely means they place a high value on stability. Such investors may have a lower risk appetite and be willing to accept lower investment returns. And older investors might have a shorter time horizon. For them, capital preservation could be the best strategy. Their portfolio balance is likely to be skewed towards more predictable, less volatile assets where the limited potential for income and growth is offset by the relatively high security and liquidity they provide.
If prices are increasing faster than your wages, your money won’t go as far. For retirees and those on welfare benefits whose income often remains fixed for a long time, this can significantly affect day-to-day spending on energy and food because these prices are usually the first to react in inflationary periods. However, energy and food are often removed from calculations by economists when they want to measure ‘core inflation’, which is a more reliable indicator of long-term trends.
Inflation can also make it more difficult for businesses to sell their products and services as prices can change rapidly. If companies can’t plan their budgets in advance, it can lead to instability in the wider economy, and this can affect people’s willingness to invest in these companies.
What impact does inflation have on investments?
Equities
When someone makes an equity investment in a company, they become shareholders with a claim to a proportion of the company’s assets and earnings. How the company performs determines the value of its stocks, but this can be affected by economic factors like inflation.
When wages are high and the underlying economy is strong, consumers can still afford to buy a company’s products. Rising profits benefit shareholders because they should see a greater return on their investment. However, when wages aren’t rising and the economy is weak, consumers can’t afford to buy goods and services. This leads to a fall in both demand and company profits, with returns to shareholders following suit.
Fixed income
Investing in bonds typically involves lending money to the issuer, usually a big company or the government. – The issuer then pays you a fixed income in return. When the bond matures, the issuer repays the original loan. As the interest rate for the repayments is fixed, high inflation will effectively devalue the income you receive.
Inflation can also affect the underlying value of the investment. If, for example, you buy a government bond for $100 that pays 3% interest but inflation is above 3%, then the value of the investment will fall. When the government repays the loan at the end of the fixed period, your original $100 will have been devalued by inflation.
What impact does inflation have on cash and savings?
The short answer is that inflation always devalues cash. The reason for this is that inflation is linked to rising prices. If you have $100 in your wallet now, you can buy a certain amount of goods or services. If inflation pushes the price of those products up to $110 next year, you won’t be able to buy as much with your $100. If you hold this money in a bank account that pays no interest, the result is the same. Indeed, if you had $100 in your bank account 50 years ago, it would only be able to buy you the equivalent of $20 worth of goods today.
However, most banks pay interest, so your $100 would grow over time. And to combat inflation, banks raise their interest rates to encourage saving over borrowing or spending. Unfortunately, banks won’t raise their interest rates above inflation, so the real interest rate you’re exposed to – the nominal rate offered by your bank minus inflation – will always be negative. For example, your bank pays you 2% interest on your savings but inflation is 3%. So the real interest rate for your savings is -1%, which means their purchasing power will decrease by 1% per year.
So, in periods of high inflation, it really isn’t worth holding cash. The returns on other investments such as stocks and bonds, however, can outpace inflation. Investing in these assets can generate significant wealth in the long term, so they should be seen as a viable alternative to cash.
Inflationary environments – what investors can do
In the short term, a little inflation can drive wage increases and even stimulate growth if the underlying economy is strong. However, if inflation remains high for longer periods, people’s savings devalue and their purchasing power decreases. Investing in high-quality companies selling essential goods and services – as well as buying safer government bonds – is usually a solid strategy in inflationary environments because these traditional investments should deliver better returns than cash.
