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If you have been following the news lately, especially about the US Federal Reserve, you would have encountered the term inflation.
The US is battling inflation, with regulators trying to bring it to a two per cent benchmark. Now, the February reading for US CPI stands at six per cent. For the Fed, it could be challenging to raise interest rates aggressively, without putting the US economy into a recession.
Headlines that say, "Fed has a long way to go to curb inflation" or "Fed minutes show members resolved to keep fighting inflation with rate hikes" are doing the rounds lately.
In its March meeting, the FOMC increased its target for the federal funds rate by 25 bps to the 4.75-5 per cent range, to curb inflation.
Meanwhile, UK CPI unexpectedly rose to 10.4 per cent in February from January's 10.1 per cent. The annual CPI rate was estimated to drop to 9.9 per cent. This compelled the Bank of England BoE to hike the key interest rate by 50 bps in March.
Inflation is a crucial concern globally, and its impact on the economy as well as your investment portfolio. So, how can inflation influence your investments? Let’s find out:
What is inflation?
Inflation refers to a rise in the average cost of goods and services, which decreases a consumer's purchasing power.
The demand and supply of goods or services play a vital role. Prices rise when there is high demand for goods or services, amid limited supply, and vice versa.
And on a global scale, many factors influence demand and supply domestically and internationally, including:
- Cost of goods
- Cost of labour
- Taxes on goods and income
- Credit access and availability
What induces inflation in an economy?
• Printing more money to citizens
• Legally reducing the value of the country's currency
• Loaning new money as reserve account credits through the banking system
In the US, inflation is measured by the Bureau of Labor Statistics. It compiles data and determines the Consumer Price Index (CPI), which over time, tracks the cost of goods like:
- Gasoline
- Food
- Clothing
- Automobiles and more
Through this, they can look at the overall change in the price of consumer goods and services.
For governmental regulatory bodies, the impact of inflation on the economy is something they must regularly check on. Most central bankers aspire to be 'inflation hawks'.
So, let's first understand the indicators of inflation.
Indicators of rising inflation
Often called 'reflation,' inflation has three primary drivers.
Monetary policies by Fed: To curb inflation, the Fed increases interest rates. A higher interest rate means higher borrowing costs for companies and consumers. When prices are high, the need to buy products or services drops, indicating a slowdown in economic activity. A higher interest rate will also impact growth stocks, hurting discounted cash flow valuations.
Energy prices, specifically oil: Oil is an essential commodity in producing and transporting goods. Thus, its demand correlates to economic activity. As such, the demand for oil, high or low, will influence inflation. Over the last year, oil prices have increased mainly due to renewed economic activity and tighter supplies because of the ongoing Russian-Ukraine conflict. And any recovery to meet the rising demand will moderate the prices.
Reducing dependency on imported products and services: Over the years, what has been witnessed is the overseas transfer of production has been to find the manufacturer promising the lowest cost. Returning to US factories will likely increase production costs, including labour and goods. This is likely to impact inflation as there is now a higher input cost to the supply side, in this case, for US factories.
How do governments try to control inflation?
Governments usually use various tools to bring inflation down:
- Implement wage and price controls (however, it can create job losses and a recession)
- Implement monetary policy measures to reduce the supply of money.
So, as we have learned how inflation is likely to occur and the impact of inflation on the economy, let us see how it is expected to impact your investment portfolio.
How inflation influences investment portfolio?
Fixed income investments
Most investors could likely add fixed-income securities such as municipal or corporate bonds, and treasuries to their investment portfolio as they wish to have a stable and continued income stream through interest payments. But when inflation occurs, the purchasing power on these interest payments drops as the interest rate on fixed-income securities remains unchanged until they mature.
Stocks
As per a US Bank Asset Management Group analysis, in the last 30 years, the inflation effects on the stock market has generally been positive, with stocks holding up well against inflation. As inflation rises, so do a company's revenue and earnings.
And for US stocks, this has mostly been true, though the relationship has not always been strong. Larger companies are likely to have a stronger relationship with inflation compared to mid-sized and small companies. Foreign stocks in developed markets are likely to drop when inflation rises, and there is a stronger negative relationship when it concerns emerging market stocks.
Real assets
The impact of inflation on tangible assets, like commodities and real estate, tends to be positive. As inflation is generally measured by tracking the price of products and services, commodities, have historically proven to be a reliable indicator of rising inflation.
In addition, as mentioned earlier, commodities, like oil, have a strong relationship with inflation. That said, commodities tend to be more volatile and have underperformed against assets like bonds and stocks. Real estate, on the hand, has been positive for homeowners, who can sell their property at a higher price or increase rents.
Special Mention:
Traditionally gold has been seen as a commodity to hedge against inflation as it is a tangible asset and holds its value.
So, how can investors defend their investment portfolios against inflation?
Over time, inflation can have a massive impact on investment portfolio. It will require an investor to be proactive and figure out smarter asset allocation methods.
Stock Market: Inflation is a punch to the bond market but is a boost to the stock market. So, when inflation occurs, investors could allocate 10 per cent of investment capital to stocks and indices. However, it is a must to do due diligence before taking decisions, as investing in markets is risky, and there are chances of losing money.
Diversify internationally: When building an investment portfolio, a look at international stocks that tend to provide good returns over the long term could be considered, as diversifying portfolio is seen to reduce overall risk.
The impact of inflation is beyond an investor's control, but its effects can be tamed.
— Arun Leslie John is the chief market analyst at Century Financial.
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