Abel Wyatt
Inflation impacts almost all aspects of the economy, right from business investment, employment rates and consumer spending, to interest rates, tax policies and government programs. Kavan Choksi Professional Investor says, understanding inflation is vital for investors as it can lower the value of investment returns. Investors need to have a good idea about the factors driving inflation, the impact on their portfolios, as well as the steps to consider as the investment landscape shifts
Kavan Choksi Professional Investor underlines the impact of inflation on investors
Inflation is largely categorized into two types cost-push inflation and demand-pull inflation. Rising commodity prices are an example of the former as when the prices of commodities go up, the costs of basic services and goods also increase. Demand-pull inflation typically takes place when aggregate demand in an economy rises too fast. This can occur in a situation when the money supply in the economy is rapidly increased by a central bank, without a corresponding increase in the production of goods and services. As demand outstrips supply, the prices of goods go up.
Central banks, like the U.S. Federal Reserve, European Central Bank, the Bank of Japan and the Bank of England try to control inflation by regulating the pace of economic activity. They typically impact economic activity by lowering or raising short-term interest rates. Management of money supply by central banks in their home regions is referred to as monetary policy. Raising and lowering interest rates is among the most common ways of implementing monetary policy. Central banks also might relax or tighten the reserve requirements of banks. Banks have to hold a percentage of their deposits with the central bank or as cash on hand. Raising the reserve requirements restricts the lending capacity of banks and ultimately slows economic activity, while easing reserve requirements typically stimulates economic activity.
Inflation is known to pose a “stealth” threat to investors as it chips away at the savings and investment returns. The majority of investors strive to augment their long-term purchasing power. However, inflation puts this goal at risk, as investment returns must first keep up with the rate of inflation in order to improve the real purchasing power.
As Kavan Choksi Professional Investor also mentions, the change in the inflation rate can have varied impacts on diverse asset classes. For instance, stocks and nominal fixed income have exhibited a negative response to upside surprises in inflation historically. This may essentially lead to a positive stock / bond correlation during periods of higher inflation and channel the traditional diversification. On the other hand, historically, commodities and Treasury Inflation-Protected Securities (TIPS) are known to display a positive sensitivity.
Very high inflation is likely to have negative effects on discerning assets like bonds and stocks. Investors should try to maintain a constant allocation to inflation-hedging assets for the purpose of cushioning their portfolios against unexpected spikes. Investors might consider inflation-mitigating amid a rising inflation environment and constantly changing investment conditions. They also should keep the core tenets of investing in mind, which include regular rebalancing, having a well-diversified portfolio and ensuring investments remain aligned with long-term goals.
