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Understanding Inflation's impact on your investments

Analysis written by Vinay Soni

A pound today will not buy the same value of goods in 10 years. This is due to inflation. Inflation is a persistent rise in the price of goods and services over time. It reflects a decrease in the purchasing power of money, meaning each unit of currency buys less than it did before. While some level of inflation is considered healthy for a growing economy, high inflation can erode savings and complicate investment decisions.

Understanding Inflation

Inflation is measured by the Consumer Price Index (CPI), which tracks the average price changes for a basket of goods and services typically consumed by households. Central banks target a low and stable inflation rate, usually around 2% annually. This allows for economic growth without significantly reducing purchasing power.

Several factors contribute to inflation, including:

  • Demand-Pull Inflation: Occurs when consumer demand for goods and services exceeds available supply. Businesses raise prices to meet demand, pushing inflation higher.

  • Cost-Push Inflation: This happens when production costs increase due to factors like rising raw material prices or wages. Businesses pass on these costs to consumers, leading to inflation.

  • Government Spending: Increased government spending can stimulate demand and lead to inflation if not accompanied by a corresponding rise in production.

Inflation and Investing

Inflation is an important consideration for investors because it eats away at the real returns (returns adjusted for inflation) of your investments. For example, if you invest £10,000 and earn a 5% annual return, but inflation is 3%, your real return is only 2%. Over time, inflation can significantly reduce the purchasing power of your investment gains.

There are ways to hedge against inflation; a disciplined investor can protect themselves by investing in assets that outperform the market during inflationary climates.

Impact of Inflation on Different Asset Classes

Let's explore how inflation affects various investment options:

  • Cash: Cash held in savings accounts or under the mattress loses purchasing power during inflation. The interest earned on cash accounts is typically lower than the inflation rate, resulting in a net loss of value.

  • Gold: Gold is known to be a good hedge against inflation. People will commonly hold onto gold when their native fiat currency is losing value or has failed. However, gold doesn’t truly hedge against inflation because it pays no yields. When inflation rises, central banks increase interest rates as part of monetary policy; therefore, generally holding onto assets which pay no yields is not as valuable as an asset that does.

  • Commodities: Commodities like gold, oil, and agricultural products are often seen as inflation hedges. The relationship between Commodities and inflation is unique as commodities are strong indicators of the arrival of inflation. As commodity prices rise, so does the price of products that the commodity is used to produce. However, commodity prices can be quite volatile as they depend on demand and supply factors. Slight changes due to geopolitical conflicts, for example, can strongly affect commodity prices.

  • Stocks: Stocks have historically been a good hedge against inflation; they offer the most upside returns in the very long run. Companies can raise prices to maintain profit margins when costs rise, which can translate to higher stock prices. Stock prices can be volatile in the short term especially considering inflation fears; however, a long-term investor will extremely benefit from riding out cycles of inflation.

  • S&P 500: The S&P 500 is a stock market index that tracks the performance of 500 of the largest, publicly traded companies listed on stock exchanges in the United States. It's considered a key benchmark of the U.S. stock market and the overall health of the large-cap American economy. The index is known to average a return of 10% which positively outweighs inflation rates. Technology and communication service companies have a 35% stake in the index which is positive for protecting against inflation because they are capital-light businesses. Capital-light businesses’ primary expenses are mainly labour which is less affected by inflation; they are also customer-service based meaning they provide value from their expertise rather than basing prices on physical goods costs.

  • Bonds: Bonds, especially traditional fixed-income bonds, are generally considered losers in an inflationary environment. Their fixed interest payments don't keep pace with rising prices, reducing their real returns. However, inflation-indexed bonds, like Treasury Inflation-Protected Securities (TIPS), adjust their principal amount for inflation, protecting investors' purchasing power.

  • Real Estate Income: Real estate is one of the best hedges against inflation because property values tend to rise with inflation therefore, landlord rents can be adjusted upwards causing the landlord to earn higher rental income. However, real estate investments require a high amount of investment and require more financial and legal liability than other asset classes. Furthermore, real estate is illiquid; it can’t be quickly and easily sold without a substantial loss in value.

  • Real Estate Investment Trusts (REITs): Companies that own and operate incoming producing real estate. These have the same benefits as real estate income and investors earn income in the form of dividends. Drawbacks include sensitivity to demand for other high-yield assets. When interest rates rise, treasury bonds become more attractive reducing demand for REITs and lower share prices. Furthermore, REIT dividends are affected by changing property taxes and taxes.

By understanding how inflation affects different asset classes you can protect your purchasing power and achieve your long-term financial goals even in inflationary environments. Remember to diversify your portfolio to mitigate the adverse effects of inflation!


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