Investing in times of inflation can be tricky. Whether cash, bonds, equities, or other asset classes, investments come with distinct risk/reward profiles. Inflation risk can impact them all.
Not surprisingly, Americans are skittish amid today's sky-high inflation. A May survey by BlackRock Fundamental Equities found that 62% of investors viewed inflation as the biggest threat to the U.S. stock market over the next six months. What's an investor to do?
But first, what is inflation?
Inflation is the rise in the price of goods and services over time. If prices increase and income remains fixed, the purchasing power of money falls. Moderate inflation is generally good news, as it can indicate an expanding economy, one with job growth and increasing wages. However, if inflation skyrockets in a short period, consumers' money quickly loses value. As customers tighten their purse strings, corporate profits can take a hit due to sluggish sales and greater costs.
Understanding inflation risk: For investors, "inflation risk" is the risk that inflation will erode an investment's returns through a drop in purchasing power. Investment returns can be measured in two ways:
- The nominal rate of return is your investment return without factoring in inflation.
- The real rate of return considers inflation. It is your investment return minus the inflation rate, which gives you the purchasing power of your investment.
In times of inflation, your real rate of return matters most.
The current state of affairs
This June, the annual inflation rate in the United States hit 9.1%, the highest level since 1981. This rise in inflation meant a carton of eggs that cost $1.60 in 2017 now had a price tag of $2.71. Indeed, the price of basic needs such as food, vehicles, and housing had all gone up, leaving less money for "extras" that were affordable five years ago. In July, inflation moderated somewhat to 8.5% year over year, partly because gasoline prices fell noticeably.
Item Price in 2017 Price in June 2022
Bread $1.35/loaf $1.69/loaf
Eggs $1.60/carton $2.71/carton
Chicken $1.42/pound $1.83/pound
Electricity $0.13/kWh $0.16/kWh
Cause and effect: The seemingly never-ending COVID-19 pandemic and recovery, an unpredictable economic lockdown/reopen cycle, and fractured supply chains have created an environment of low supply and pent-up demand. With nowhere for people to go and nothing for them to do over much of the pandemic, and with the help of government aid programs, consumers' wallets swelled, creating a strong spending cycle and pushing up prices. The ongoing war in Ukraine and the rising cost of labor and oil further exacerbated inflation.
To take the air out of inflation, the U.S. Federal Reserve Board has raised interest rates to lower demand, with more rate hikes expected this year. It would appear we're going into a full-scale war against inflation.
As a result, the S&P 500 has dropped more than 10% this year (as of mid-August), following solid stock market performance in 2021. Americans who invested heavily, expecting the low inflation and interest rates of the last two years to continue, are now left scratching their heads.
Implications for the bond investor
For most investors, bonds tend to be most vulnerable to inflation risk because their payouts are generally based on fixed interest rates. As inflation increases, it eats into a bond payment's purchasing power. For example, if an investor bought a 30-year bond that pays a 4% interest rate, but inflation is sitting at around 8.5% as it currently is (as of July), that bondholder is losing significant purchasing power with each passing year.
But rising inflation isn't bad news for all bonds. Variable-rate investments can cushion the blow because their payments are based on an index that changes with inflation rates, such as the prime rate.
Inflation-linked bonds, such as Treasury Inflation-Protected Securities (TIPS) and I bonds, are one such investment. Returns are tied to the cost of consumer goods, which helps protect purchasing power.
Convertible bonds may also hedge against inflation, as they sometimes trade like stocks. As stock prices are affected by fluctuations in inflation, these bonds can preserve purchasing power to some degree.
Implications for the equity investor
Unlike the typical bondholder, many equity investors may have less reason to panic. History tells us that high inflation is associated with lower returns on equities, but not all stocks are created equal. Value stocks can be solid performers as long as inflation doesn't go haywire — above 10%, a rare occurrence and one not expected in this period. As much of their expected cash flows are front-end loaded, value stocks can return capital to shareholders faster than growth stocks, which gives them an edge in cycles of moderate-to-high inflation.
By contrast, growth stocks are back-end loaded. These longer-term assets promise cash flows in the distant future and do best amid modest inflation and low interest rates.
Still, growth stocks are nothing to scoff at. Our current high-inflation, high-interest-rate environment has been a drag on growth stock performance this year, but many companies continue to innovate and power ahead. Therefore, growth stocks could still be a solid long-term investment.
Stock performance also varies by sector. Cyclical stocks such as financial, energy, and resource companies tend to shine when the economy is booming or recovering. On the flip side, stocks in energy, utilities, and consumer goods often slump in inflationary times.
Many analysts don't expect high inflation to last for an extended period. However, consumers aren't convinced: the median one-year-ahead inflation expectations were 6.2% in July, although this was down from 6.8% in June. Inflated inflation expectations can end up being a self-fulfilling prophecy. Naturally, worries of a recession in 2023 abound.
The truth is, COVID-19 has made it exceptionally difficult to anticipate where the economy is headed. Today's economists, policymakers, and analysts have no experience assessing the financial fallout of a once-in-a-lifetime pandemic, and many have been consistently wrong in their predictions.
What's an investor to do?
No one knows what's coming, which is cold comfort for the average investor. But even in these uncertain times, tried-and-true investment principles hold.
First, it's always best to manage risk, whether from inflation or other sources, through a well-diversified portfolio — one with a mix of assets that are diversified across sectors, markets, currencies, and even countries.
Second, it's important not to panic. Despite the market volatility of the moment, investing and inflation are not mutually exclusive. A prudent and measured investment approach that covers a variety of scenarios is critical.
Once a clearer picture of the post-pandemic investing regime emerges, investors can regroup and recalibrate. In the interim, they can take heart: If history is any indication, inflation tends to be a temporary issue with a manageable impact on long-term investing goals.
— Anish Chopra, CPA (Canada), CA, CFA, CBV, is managing director at Portfolio Management Corporation in Toronto. He is a member of the AICPA's Personal Financial Planning Executive Committee. To comment on this article or to suggest an idea for another article, contact Dave Strausfeld at David.Strausfeld@aicpa-cima.com.