Inflation is a hot topic in 2022. Global issues are putting pressure on the outlook for economic growth and driving up prices in both developed and emerging nations. The United Nations Department of Economic and Social Affairs in its June 2022 Briefing: World Economic Situation and Prospects states the following:
The world economy is facing substantial inflationary pressures. Global inflation is projected to increase to 6.7 per cent in 2022, twice the average of 2.9 percent recorded during 2010–2020. Headline inflation in the United States has reached the highest level in four decades.
The effects of inflation can devalue the worth of investment holdings, so it is important for investors to be aware of the potential impacts and consider their strategy for investing during inflation.
What is Inflation and How Does it Work?
Inflation is a measure of the fall in value of a currency over time, which usually leads to increases in the cost of goods and services. Inflation is measured by comparing the average cost of a standardized selection of goods and services in a country or region over a given period. Price rises are expressed as a percentage, reflecting that a unit of currency has less purchasing power than in the past.
The Consumer Price Index (CPI) is a common metric used to report inflation figures.
Inflation is calculated as the percentage change between the CPI Index Value on two different dates. CPI is generally calculated monthly, seasonally adjusted, and reported as an annual figure.
Historical CPI figures such as those produced by the US Bureau of Labor Statistics can be used to calculate examples of inflation and its effect on the purchasing power of a basket of consumer goods and services. For example, in the 40 years between January 1977 and January 2017, the US CPI increased from 58.5 to 242.8, which leads to the following inflation rate calculation:
Inflation rate = (242.8/58.5) x 100 = 415%
So, in the above example, $1,000 in January 1977 would be equivalent to $4,150 in January 2017. This means purchasing the same reference basket of goods in January 2017 would cost 4.15 times what it would have cost in January 1977.
The US Bureau of Labor Statistics has a useful CPI calculator that can be used to calculate CPI changes and monetary values between different times in history.
Types of Inflation
There are three main types of inflation, which can be summarized as follows:
- Demand-pull inflation, where the demand for products or services outstrips the supply capacity.
- Cost-push inflation, where increasing costs of wages and materials drives up the supply price.
- Built-in inflation, also referred to as the wage-price spiral, which can contribute to an increase on both the demand and supply side.
Causes of Inflation
The main causes of inflation are summarized below:
- When the demand for goods or services outstrips the supply capacity.
- When increases in the cost of production drive up the supply price.
- Rising wages, which can both increase demand and increase supply costs.
- Currency devaluation, which is a downward adjustment of the exchange rate of a currency.
- Increased money supply, which refers to the total amount of money in circulation in an economy.
- Policy and regulatory impacts, which can contribute to cost-push or demand-pull inflation depending on the nature of incentives or regulatory requirements.
How Does Inflation Affect Investing and Assets?
The impact of inflation on investing and assets varies depending on the nature of the investment or asset. This highlights the importance of portfolio diversification, which can help to insulate investors against the impacts of inflation. The most obvious effect of inflation is the reduction in purchasing power over time. In a high-inflation environment, money will buy less goods and services than it used to.
High inflation can create uncertainty in the economy and volatility in the stock market and can lead to intervention by central banks as they raise interest rates in an effort to curb inflation. Rising interest rates can negatively impact the value of some investments, such as long-term fixed interest bonds. The price of bonds usually declines with a rise in interest rates.
What to Invest in During Inflation
An inflation surge presents an opportunity for investors to carefully consider what to invest in during inflation. This can include reviewing their investment portfolio, assessing their vulnerability to inflationary effects, and evaluating potential options to protect downside risk and optimize returns. Portfolio diversification is an important topic on its own, which will be covered in future blog posts.
Investment strategies during inflation should take into account risk, asset allocation, and the potential for returns to rise along with inflation. Options to consider could include:
- Stocks in companies that are somewhat insulated from the impacts of high inflation. This might include those that operate in sectors without high capital requirements, or those that have a revenue model linked to CPI increases.
- High-interest cash deposits at variable rates, with the potential for returns to increase with rising interest rates that generally accompany an inflationary environment.
- Treasury Inflation-Protected Securities (TIPS), which are US Treasury bonds that provide protection against inflation because both the principal and the interest move with inflation.
- Short-term bonds, with returns that are more likely to move up with interest rate increases, compared to long-term bonds.
- Real estate, which has the potential for rental income to rise in line with CPI increases. Real Estate Investment Trusts are an alternative to purchasing direct property.
- Commodities such as oil, metals, and agricultural products, which often increase in price along with inflation.
- Alternative investments with the potential for outsized returns and that may not be highly correlated with the traditional public market.
All investments carry risk and past performance is not a guarantee of future performance.
How to Invest During Inflation
As noted above, an important element of investing during inflation is a strategic review of your investment portfolio. Asset allocation and balancing risk mitigation against investment returns are important considerations for how to invest during inflation.
Managing risk levels without getting carried away chasing high returns to keep track with inflation is a delicate balance that requires an appropriately diversified portfolio that is not too heavily weighted in a small number of sectors.
Pros of Investing During Inflation
The pros of investing during inflation may include:
- Taking the opportunity to review your investments and develop an appropriately balanced portfolio.
- Deploying appropriate investment strategies during inflation can minimize the impact of currency devaluation and maintain buying power.
The Importance of Risk Profile When Investing During Inflation
Inflationary risk refers to the risk that inflation will diminish the future real value (adjusted for inflation) of an asset or investment. Examples of this include long-term bonds or fixed interest investments that do not increase along with inflation.
An investor’s risk profile plays an important role in the selection of investments within a portfolio. Risk factors depend on an investor’s own personal circumstances such as age, parenting status, insurance cover, health, income-earning capacity, capital reserves, investment knowledge, investing experience, and more.
It is important for investors to be measured in their response to inflationary conditions and not to panic at the sight of high inflation figures that can decrease the future purchasing power of their funds. Chasing returns to beat inflation should not come at the emotional expense of investor stress caused by a level of risk that cannot be tolerated by the investor.
Inflation can cause concern for investors because of the potential for their wealth to lose value over time. An active approach can help, including reviewing the balance of an investment portfolio for diversification and the exposure to risk and potential high-growth investments that can meet or beat inflation.
If you are interested in building your portfolio by adding investments in startups, you can find more information here on how to start angel investing and how to find opportunities for angel investing on the Propel(x) platform.
This article is for informational purposes only. We do not provide legal, financial, or tax advice and investors should consult their advisors prior to making any investment. As with any investment, past performance is no guarantee of future performance, and any investment decision must balance the risk against the potential return. Private investments are highly illiquid and risky and are not suitable for all investors. There is no guarantee that a liquidity event will ever take place.
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