Is inflation good or bad for your investments?
Updated: Jun 8
The last week’s rise in inflation expectations sent a mixed signal and caused a spike in volatility in the equity market. It is generally true that the stable and reasonable inflation level, typically around 2%, is healthy for the economic growth and subsequently the financial market. However, recent monetary stimulus and growing spending among Americans may result in rapidly growing inflation, as a result, many start to question if their investments are protected from inflation.
It is generally true that the modest rise in inflation expectations leads to a growth in equity markets. Historically, we experienced growing equities alongside modest growth in inflation. However, economists and investors start to question this tendency as inflation numbers appear to grow at a higher rate or at least have a greater potential to grow at a higher rate than expected.
To begin with, it is important to understand what your investment portfolio consists of and how higher inflation may affect its growth. The typical portfolio of stocks and bonds, a 60/40 split, has a reasonable exposure to inflation and at the healthy level of inflation, both stocks and bonds enjoy an opportunity for positive and consistent returns. However, if we introduce a growing level of inflation that reaches beyond a healthy 2% level, the picture becomes less bright fast.
As inflation rises, borrowing and production costs go up squeezing companies’ margins resulting in a weaker performance and therefore poor financial results. Subsequently, poor results lead to reduced earnings growth expectations and downward pressure on stock prices. Most consumer staples/discretionary, utilities, healthcare, and some tech companies would suffer the most because they may not be able to pass the costs onto consumers. As a result, in times of elevated inflation, such stocks might not be a good investment choice. On the other hand, the biggest beneficiaries of inflation are financial and energy companies, who, typically, can easily pass through raising costs to their consumers.
In terms of the fixed income part of your portfolio, the picture may be somewhat dismal. When inflation rises to an unhealthy level, the Federal Reserve starts to increase the interest rate to calm down an overheating economy. As interest rates rise, yields on fixed-income instruments go up as well. However, investors need to keep in mind an important fact, bond prices fluctuate and in a growing interest rate environment bonds tend to lose their value. Moreover, fixed income products deliver fixed regular payments, which might become much less attractive in growing inflation and interest rate environment. Still, those who invest in short-term debt or purchased long-term bonds after interest rate increases would most likely enjoy much better returns on their fixed-income investments. Furthermore, rising interest rates typically improve the profits of financial institutions that can profit from higher interest rates on their loans. Therefore, investments in the financial sector are likely to outperform the broad market during periods of higher inflation and interest rates.
In addition, the market has created several financial products, which are designed to protect investors from rapidly rising inflation. By investing in inflation-protected securities such as inflation-indexed bonds or Treasury inflation-protected securities (TIPS) investors can protect their purchasing power and investment returns. Although such products would not produce great returns, they would protect from rapid spikes in inflation.
So, is inflation good or bad for your investments? There is no definitive answer, however, such periods in the economy create some opportunities and possibilities for higher returns, which investors should keep in mind and utilize in their investment decision-making.
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