What is inflation?
Inflation is an economic term that describes the rise in the price of
goods and services in an economy. It is usually represented in
percentage terms from one year to the next. Inflation causes the value
of money to decrease over time.
What that means: you will need to spend more for the same item or receive less (a smaller format) for the same amount of money, this can be called shrinkflation. Another term often used to describe the effects of inflation is decreasing purchasing power.
What causes inflation?
There are many factors that can cause inflation, either individually or in combination. If we take a closer look and strip away the layers to get to the core reason, the main cause of inflation is an imbalance between supply and demand. Too much demand, and prices will increase. On the supply side, if we have a disruption or not enough can be produced, prices will increase even if the demand has stayed the same.
Having a certain amount of inflation is to be expected. In fact, most central banks in developed countries including Canada have tried to maintain a target inflation rate in the 1% to 3% range per year. When inflation increases and remains above the established target rate, or a sudden spike occurs that becomes problematic.
What are the types of inflation?
Economists have identified the three main types of inflation: Demand-pull inflation, cost-push inflation and built-in inflation.
- Demand-pull inflation is when there is more demand for goods and services than the current capacity (supply) is able to meet. This will ultimately cause the price to increase.
- Cost-push inflation is when production costs are more expensive, and producers increase market prices of the good or service as a result to reflect the added costs. This type of inflation is associated with supply issues (constraints, disruptions, etc.…).
- Built-in inflation is the result of the two previously mentioned types of inflations. With the cost of goods and services increasing workers will demand higher salaries from their employers to combat the erosion of their buying power.
How does inflation affect my investments?
When inflation surpasses the central bank's target range and persists, it can have a negative effect on your investments. A typical investor will allocate their investments between the three historical asset classes like cash, bonds and equities. The effects of inflation will vary for each one.
Most investors will hold a certain amount of liquidity (cash) within their investment accounts. Inflation will erode the value of your cash holdings; the higher the inflation rate, the worse the effect will be.
When the inflation rate increases, an investor who holds fixed income securities will be negatively impacted by this change because the price of the bond will decrease. One of the tools that central banks will use to combat inflation is to increase interest rates, which have a direct negative impact on bond values.
The value of a bond is determined by the present value of all its future cash flows (interest payments). When interest rates rise because of inflation, those future cash flows are now worth less. The bond value decreases when the interest rate increases, all else being equal.
In general, equities will tend to perform better than the two other asset classes when inflation increases. The reason is that companies can, to a certain extent, pass on the extra costs to their clients via increased prices for their goods or services in order to maintain or expand their profit margins.
If inflation continues to increase, eventually this could lead to a recession where even the best companies could suffer.
How can I protect my portfolio from inflation?
There is always an element of risk when investing. Portfolios don’t always go up in value and a certain amount of volatility should be expected. The good news is that an investor can apply certain strategies that can help during inflationary periods.
Fixed income securities
As mentioned in the previous section, bonds react negatively when inflation and interest rates increase. One point worth remembering, when holding individual bonds that have dropped in value, is that unless you have concerns about the bond issuer defaulting, at maturity the bond holder will be paid the face value of the bond. As the bond approaches its maturity date, the bond price will increase to reach its face value price.
Another option when making a new purchase or deciding what to do with a matured bond, is to select a shorter maturity versus going long term. The price of the bond will be less affected by inflation and interest rate increases, because of its shorter maturity date, the investor will get their money back faster.
One of the first rules investors learn when investing in equities, is to diversify their assets. You can improve your returns and lower your risk by investing in different geographical areas outside of Canada. Not all economies will be affected by inflation or even experience inflation in the same way. Having a diversified portfolio can offer a measure of protection.
Another form of diversification is by sector. Some sectors are more resilient than others when the inflation rate increases, while others can even benefit from inflation for a while.
Value stocks tend to better perform or hold their own in a rising inflation rate environment than, for example, growth stocks. These companies tend to be in mature industries with consistent earnings and usually lower debt levels, and that might be part of the reason why they outperform other assets. During times of uncertainties, investors will look for stability, which some believe value stocks provide.
Dividend paying securities
Dividend paying securities can offer a measure of protection during periods of inflation. In some ways, they share many of the characteristics of value stocks: They are stable mature companies that generate reliable earnings. This allows them to be able to pay dividends but, more importantly, increase them over time. If the dividend growth rate is equal or higher than the inflation rate, investors might not have the purchasing power of their dividends decreased versus, for example, a bond whose interest payment is fixed during the duration of the bond.
During periods of inflation, the price of buying and the cost of producing goods will increase. To create these products requires the input of commodities, these raw materials can be mined (copper, gold), drilled (oil, natural gas) or grown (wheat, cattle).
The price of commodities is affected by demand and supply issues and during periods of inflation will increase in value and provide a natural hedge.
Holding physical commodities in one’s portfolio can be challenging but there are Exchange Traded Funds (ETFs) available that a self-directed investor can purchase. These ETFs can either hold the physical assets or a proxy using derivative products.
Inflation is a risk that investors must not only factor into their personal budgets but also their investment decisions. Although one cannot completely hedge themselves against the effects of inflation on their portfolio, being properly diversified can make a difference.