Is Inflation Good for Investors?
Is inflation good for investors? There’s been a lot of discussion in the media and online about inflation over the last few weeks. Perhaps with good reason. This post explains inflation and considers whether is there a case for welcoming higher inflation?
What is Inflation?
Inflation is the rise in the cost of goods and services in currency terms over time. Generally, it is agreed that a low level of inflation is acceptable. Many economies target around 2% per annum.
Why Does Inflation Occur?
Inflation can occur due to shortages in commodities such as the raw materials required to make goods. This may be a poor harvest for cereal crops. Economics tells us a tightening of supply increases cost. Where services are considered, low unemployment rates mean employers need to pay higher wages to attract or retain employees. This is technically referred to as ‘cost-push’ inflation.
Another type of inflation is where there is an abnormally high demand for products or services. This usually occurs when there is high employment and wages are rising. As a result, people are confident about the future. This causes higher demand for the raw materials required for the manufacture of the desired goods. Companies then compete for the supply and prices rise.
How Is It Measured?
Different economies have different methods of calculating their inflation rate. There are also different types of inflation. For consumer price inflation, most countries use a basket of goods and services which a ‘typical household’ may use. This basket changes over time – for example, the cost of video cassettes is no longer included in the UK calculation of inflation. Each economy includes the services they wish to track. Therefore, using official inflation rates to compare the change in cost of living between countries may not be an accurate measure.
UK inflation rates are published by the Office for National Statistics (ONS). The main inflation indexes are Consumer Price Index (CPI) and Consumer Price Index (Households) CPIH. The difference is the CPIH includes the costs of household owner occupiers. In April CPI was 1.5% and CPIH was 1.6%.
Why Is Inflation Important?
If compounding of growth were a superhero, inflation would be its nemesis. Inflation erodes the purchasing power of our money over time. If inflation is not kept in check, it can run out of control. This can have devastating effects to the economy on which we all depend. Faith in the value of money is destroyed.
The specter is hyper-inflation. Hyper-inflation is defined as where inflation exceeds 50% per month. In the last century or so, 28 countries have experienced this. Many of them in Europe but more recently in Africa. Zimbabwe famously issued a Z$100 Trillion note in 2008 but it would not even buy half a loaf of bread. (source: Dallas Federal Reserve)
At this level, cash, the lifeblood of our economy, becomes worthless, and trade breaks down. One of the key tenets of money is that it must be a store of value as well as a means of exchange. Hyper-inflation undermines the store of value. Ultimately it is no longer accepted by people in their daily transactions.
What Is A Good Rate of Inflation?
Many Central Banks are tasked with maintaining inflation at a low level. This is around 2% per annum. At this rate it would take 35 years for the purchasing power of your money to be halved. Some inflation is a good thing. This encourages economic activity – buy now as it will be more expensive in the future.
Having a stable rate of inflation is also important. This enables companies to make long-term investments and to calculate the real return on those investments.
Who Is Most At Risk?
Generally, during times of moderate inflation (not hyper-inflation) those who are in employment see their wages rise and so they are reasonably protected against normal rates of inflation.
So is inflation good for investors? Those who are relying on fixed incomes such as pensioners and the majority of fixed income securities investors are most at risk.
How To Combat Inflation
Inflation is a risk which can be reduced by investing in “real” assets. Real assets are those which may be priced in terms of currency but have a separate utility. Property, shares (equities) and commodities are examples of real assets.
Physical property can be an investment or a place to live. Rental income tends to rise with inflation. A property’s value is, at least in part, a function of the rental yield.
Shares represent ownership of a company and provide the shareholder with a right to future profits. As raw material costs rise, most businesses will eventually pass these on to customers in the form of higher prices, or they will fail. Successful businesses generate profits and shareholders receive capital growth and/or dividend payments.
Commodities are the raw materials used in the manufacturing process as well as ancient stores of wealth. In times of high inflation, they can combat the erosion of value. However they are relatively high risk and do not usually form a large part of an investor’s portfolio.
Inflation Linked Gilts which are UK government securities theoretically offering a return above inflation. These investments were in very high demand during the last sale in March. The demand was so high investors paid a price which gave a return of almost 2.6% BELOW the rate of inflation for bonds maturing in 2031. (source: Reuters) That means investors will lose money in real terms, i.e. they will be able to buy less with their money in 2031 than they could have done in 2021. So Inflation Linked Gilts are not currently a way to protect against inflation.
Is Inflation Good For Investors?
This will depend on where your money is invested. Investors should focus on the real return on their money. That is the return after taking inflation into account.
Most banks are not paying any interest on cash deposits, but inflation is rising. This means those holding cash (beyond their strategic allocation for emergencies) are losing value.
For those invested in fixed income securities (bonds) inflation will reduce the real returns they receive when their bonds mature.
Investors in equities (shares) should see continued growth if they have a well-diversified portfolio. Not all sectors of the economy or companies will do well. This is because they will not be able to pass on their increased costs of production to their customers.
The impact on property investors will be split into two. Those who are borrowing money to buy the property and those buying for cash. As inflation rises, we can expect interest rates to rise. This is a standard monetary policy used by most central banks. This means the cost of mortgages will rise, perhaps faster than rents. Those who do not have loans on their property will fare better as their cost of ownership should not increase.
Nobel prize winner Eugene Fama said recently, “…inflation is one of many risk factors long-term investors must prepare for.”