Inflation devalues the money you earn from investing, so it should be given some special consideration - but there is no need to worry! There are actions that you can take.
Why is inflation bad for investors?
John Maynard Keynes, the legendary economist, described some inflation as a good thing. Keynes argued it helps prevent the paradox of thrift. It stimulates the economy by encouraging people to spend. The crux of his argument is you are more likely to buy something today if you know it will cost you more in the future.This incentive to spend increases the demand for goods and services. If this is true, why is it that there is such disdain for inflation?
In 1977 David R Morgan published a piece of work titled over taxation by inflation. Morgan argued that by failing to amend tax bands to match the higher cost of living during the 70s, the government had essentially shifted an extra tax burden onto the general public.
Nominal and real returns
There is a widely accepted logic that global stock markets tend to return around 9-12% a year on average over a long period of time. That number comes from 120 years of returns, as presented by Credit Suisse. Of course, the returns year to year can vary wildly. 9-12% is a nominal return.
If inflation is at 9% and your investments make a nominal return of 9% then your real return is nothing. You have not moved up the hill at all. You are right where you started.Real returns are what investors should care about and inflation is a disaster for real returns. It eats away at the return rate you achieve by destroying the value of the money you are making.
What causes inflation?
A prerequisite for price inflation is monetary inflation i.e. central banks printing money. An increase in the money supply reduces the value of the money already in existence.The government benefits from this in two ways. It reduces the real value of government debt and also improves nominal tax revenues. The government can use the devaluation of money to make their debts worth less and rising prices to make their income look better on paper.But inflation is a disaster for households. The value of their savings and their wages shrink as the currency they work so hard for can purchase fewer goods and services over time.Investopedia created a timeline of the cost of a cup of coffee to demonstrate the real-life effects of inflation.
How inflation has changed the price of a cup of coffee over time
This is why there are so many negative quotes about Inflation.Inflation is the devaluing of money. It hurts everyone who earns a fixed amount of money, like a salary. It’s imperative to outrun it by increasing your earnings above CPI. Think of inflation like a hill. The steepness of that hill is the rate of change in prices, and the steeper it is, the harder it is for you to make it to the top.
Could you beat inflation?
Should investors prepare for higher inflation? Yes. The only choice is to attempt to outrun inflation. That means putting your money in assets that return more than the rate of inflation.
The above graph demonstrates the performance of stocks, savings and cash over 20 years. Equities (another name for stocks) dramatically outperformed the others and is the only asset that gained value over the time period, even when accounting for inflation. Cash and savings accounts lost value.
One of the reasons the stock market acts as a good defense against inflation is that many businesses have the ability to increase prices. In fact, a general environment of rising prices can only happen when businesses raise their prices. The ability to raise prices gives those businesses the unique ability to continue to grow ‘real profits’. Investing your money into these businesses that can still grow profits is a form of inflation hedging for long-term investors.This contrasts with cash which is specifically what is losing value and bonds which are in essence IOUs that have fixed regular payments (like a salary) known as the coupon that lose real purchasing power.However, not all businesses can magically sidestep inflation.For example, Kraft Heinz was arguing with the UK supermarket chain Tescoabout its proposed price increases. Heinz said it needed to raise the price of Heinz tomato ketchup, but Tesco disagreed. The stalemate left Tesco's shelves empty of Heinz products. This is an example of a company’s inability to pass on the costs of inflation to consumers.
What does inflation mean for investors?
Rising interest rates are the standard policy reaction of central banks to high inflation. So when considering the right course of action, investors must also consider the impact of rising interest rates.
So as interest rates rise to combat inflation, there is an increasing number of incentives for investors to pull funds from the stock market.
Inflation forces investors to scramble for solutions
Both inflation rising and Interest rates going up in 2022 marked the return of market conditions not seen since the 1970s. As represented by 10-year Treasury yields, interest rates peaked in the early 1980s and trended lower for close to 40 years.
USA 10 year treasury yields 1962-2021
Is inflation good or bad for investors? Nobody knows for sure. That means there is uncertainty around how stocks will perform if inflation remains high. And if there is one thing markets hate it is uncertainty.But whilst it is new for many investors, world markets have been through periods like this before. We all know that past performance is no guarantee of future results but for the last 100 years, the stock market has outpaced the returns of other assets.
Seeing your stock market investments fall in value is an emotional challenge. As an investor, you have to remind yourself that even when things seem bad, we can never know what the markets will do in the short term so you shouldn't be trying to amend your investing strategy in reaction to short-term factors.The most important thing we can do as investors is to keep running up that hill.