Inflation and Your Investments

If you have read the financial press recently, you may have noticed some speculation around inflation.

Modest inflation is good for the economy. It indicates prosperity and encourages investment. The government target for inflation is 2% per year.

But after an unprecedented year, when growth across many industries stagnated, inflation is starting to reach concerning levels. The annual change in the Consumer Prices Index (CPI) rose from 0.7% in February 2021 to 2.4% by June. While this is only slightly above target, it is generally moving in an upwards direction, despite still including periods of heavy Covid restrictions.

So what is causing the rise in inflation, and what does this mean for your investments?

What Causes High Inflation?

High inflation occurs when prices rise more quickly than anticipated. This, in turn, is usually fuelled by increasing demand.

Low interest rates also have an effect, as this can make borrowing and spending more attractive than saving and investing.

We are currently in an unusual position. The pandemic has led to almost 18 months of restrictions, when travel and hospitality ground almost to a standstill, while home technology and delivery services thrived. This has led to an unbalanced economy.

In addition, we are starting to see the effect of ‘pent-up demand,’ as consumers spend some of the money they have saved. This could indicate that some of the price spikes we are seeing now are temporary.

But economic oddities can mask the bigger picture. Covid may have accelerated certain trends, but other factors, such as Brexit, climate change, and technological advances mean that the world was already changing. Increased costs for businesses can mean a more sustained rise in prices.

What Happens When Inflation is High?

When inflation gets too high, several things happen in a self-perpetuating cycle:

• Demand outstrips supply, which can lead to shortages.
• Wages and benefits struggle to keep up with higher prices, pushing many families into relative poverty.
• Businesses face rising costs, and may need to make cutbacks to remain profitable.
• Workers are made redundant, and businesses fail.
• The economy shrinks and slips into recession.

High inflation also has an impact on investments.

Bonds

Bonds will form the majority of the ‘lower risk’ element of your portfolio. They generally offer stable prices as well as an income yield.

When inflation is high, this has the following effect on bonds:

• Interest rates rise, which can make it more appealing to hold cash rather than invest.
• Newly issued bonds offer higher yields to keep pace with inflation and interest rates.
• Existing bonds with lower yields fall in price, which can cause investment portfolios to drop in value.
• Losses are compounded by the drop in ‘real value.’ If the asset, and the income generated do not keep up with inflation, this results in a net loss in terms of purchasing power.

Equities

Equities will form the ‘growth’ element of your portfolio. They are more likely to produce strong returns, but can be more volatile.

When inflation is high, this has the following impact on equity investments:

• Generally, equities have a better chance of keeping up with, and exceeding inflation.
• This can increase demand, which leads to rising share prices.
• This makes equities more expensive to purchase, but also means that an existing portfolio will rise in value.
• Equities that produce a strong dividend yield will be in particular demand.
• But remember, market sentiment is not the only factor affecting share prices. A real business lies behind the fluctuating figures, and it is not immune to economic forces. High inflation can result in increased costs, cutbacks, and falling dividend rates, which can, in turn, cause the share price to plummet.

While due diligence can help to assess the investment value of a company, it’s not always easy to see how inflation will affect it. Some companies will prosper while others struggle. Simply holding equities is not a fool-proof way of beating inflation.

Constructing a Portfolio

All types of investments can be impacted by inflation, but investing is still the best way of ensuring that your money holds its value.

A good investment strategy has the following characteristics:

• It is held for the long term. A minimum period of five years is needed to smooth out the majority of the volatility, but ten years or more is even better.
• It holds a wide range of assets. This does not only mean holding equities as well as bonds, but investing across different geographical regions, business sectors, and company types.
• It does not attempt to time the market or make judgement calls about the best thing to invest in right now. Investors do not have a crystal ball, and the economy (and the companies within it) do not always behave as expected.
• It balances risk and reward potential depending on the investor’s goals, objectives, and attitude to risk. A portfolio containing a higher proportion in equities is higher risk, but also provides the best chance of beating inflation.

What Can You Do?

The economy is cyclical, and while the inflation rate rises and falls, it normally remains at controllable levels. The Bank of England can also alter monetary policy if necessary. For example, increasing interest rates would make saving more appealing and borrowing more expensive, which could help to curb spending.

High inflation can cause some discomfort in the short term, but over a lifetime of investing, it normally evens out.

So what can you if you are concerned above high inflation?

• Keep your spending under control and make sure you keep an emergency fund in place.
• Stick with your investment strategy. Even when the market is volatile, taking money out is likely to leave you worse off over the longer term.
• Hold a balanced investment portfolio with a diverse range of assets.
• Avoid gimmicks, hot stocks, and expensive investments.
• Remember that you can alter your risk profile (and therefore the balance of bonds and equities) at any time. We do not charge either to reassess your investment strategy or to carry out the necessary trades. Transaction costs are generally minimal.

Our unique TRAILS™ process gives more detail about the different risk levels that we can apply to your portfolio. Please don’t hesitate to contact us to find out more.