Inflation is the continuous and consistent increase in the general price level of goods and services in an economy. It is generally good for investors as it means the value of assets increases in value.
Inflation can be Good for Investors
As the price level of goods and services increases, businesses make more money in sales and profits. These profits can be used to pay investors more money in the form of dividends or to reinvest in the business to increase revenues and profits, ultimately making companies more valuable.
Inflation can be Bad for Investors
When inflation rises beyond a certain point, consumers will not be able to afford to pay for goods and services if their incomes don’t rise to match.
If consumers cannot afford to buy as many goods, company revenues and profits will fall, which could cause an economic recession. For assets like real estate, if people looking to buy homes cannot afford to pay more for houses, prices will fall.
This is why Central Banks set inflation targets to allow for long term sustainable growth. While inflation is generally suitable for investors, too much inflation can be harmful.
How Inflation Affects Different Assets
Inflation affects assets differently. Some investments perform well when inflation is rising while others suffer. While it’s difficult to precisely predict how each asset will perform, we can look at history and economic theory to get a clue.
Cash is popularly known as the worst asset to have as inflation rises. As a major definition of inflation is the steady decline in the purchasing power of money. In 2016, it cost a family of five ₦4,087 to make a pot of jollof rice. Last month, the same quantity cost ₦8,590.
That is, the ₦4,087 someone had six years ago that was “strong/powerful enough” to cook one pot of hot delicious jollof rice is no longer “powerful enough” to cook the same today. The purchasing power of cash has reduced, and inflation has occurred.
Even cash left in savings or fixed deposit accounts is still not protected because the interest bank accounts pay is significantly lower than inflation. Nigerian banks offer less than 2% interest on a savings account on average. Nigeria’s inflation is over 15%.
A bond is a promise from one person known as the issuer to pay another person the money borrowed (principal) and interest (coupon) regularly. It is an asset that allows governments and companies to borrow money from investors.
Bonds allow issuers to borrow money from investors today, pay the agreed coupons over the bond’s life, and pay the principal upon maturity. E.g. If a company issues a 10% $100 bond with a life of 5 years, the company will pay $10 to investors every year, and at the end of the five years, the company will repay the $100 principal.
Bond issuers can choose to pay investors fixed or variable coupons. When the issuer initially offers the bond for sale, they state the type of payment structure they’ll use.
Inflation is very damaging to fixed-rate bonds because it reduces the value of the coupons paid over the life of the bond and the principal paid at the end. A bond that was paying ₦4,000 in 2016 could cook you a pot of Jollof, but that same bond can no longer do the same in 2022.
If the inflation is higher than the interest rate, investors are essentially losing money after adjusting for inflation. However, there is a type of bond that protects investors against inflation. These bonds are called Inflation-Linked Bonds (ILBs).
ILBs have their coupons and principal linked to the inflation rate in an economy. The coupons and principal that investors get from holding ILBs rise and fall with inflation.
Investors can own real estate either directly by owning a house or land or indirectly through Real Estate Investment Trusts (REITs). Real Estate is often referred to as a store of value. The asset class has performed relatively well historically during high inflationary periods.
Investors who own rental properties will generally still be able to rent out their property as inflation rises because housing is a necessity. However, as inflation increases, Central Banks are more likely to raise interest rates.
Higher interest rates can be bad for owners of rental properties and those who sell houses. As interest rates rise, the rate banks charge on mortgages (home loans) rises. An investor who bought their rental property with a floating rate mortgage will pay higher interest on their home; thus, they would have to increase rent to afford their mortgage.
Higher mortgages also mean it is more expensive for people to buy houses. It also reduces the number of people that can qualify for loans to buy homes.
Commodities are a broad category that includes natural gas, petroleum, precious metals, minerals, grains, electricity, currencies, emissions, and other financial instruments. Commodities have historically been seen as an indicator that inflation is to come.
As commodity prices rise, the price of the products that the commodity is used to produce rises as well. Commodities have historically performed well in high inflationary periods.
Investors don’t generally own physical commodities like a barrel of oil or a bar of gold in their homes. They use commodity derivatives to invest in commodities. Commodity derivatives are traded on exchanges like stocks.
Investors can also invest in multiple commodities via exchange-traded funds (ETFs) like the iShares S&P GSCI Commodity-Indexed Trust (GSG).
Gold is often considered one of the best hedges against inflation. Gold used to be the global reserve currency before it was replaced by the US Dollar almost half a century ago. Some investors still view gold as a reserve currency.
When inflation rises and the value of traditional currencies like the US dollar falls, investors look to the old reserve currency as a safe haven.
However, gold is not a perfect hedge against inflation. Central Banks tend to raise interest rates to combat high inflation. Gold doesn’t pay dividends like stocks or coupons like bonds. This reduces the value it can offer investors when interest rates rise.
Stocks can be good as a long-term inflation hedge but can suffer in the short term if inflation spikes. Not all stocks are created equal. The stocks of high growth companies suffer as inflation rises while value companies perform better.
Growth companies are fast-growing companies catering to a rapidly growing customer base. These companies have to spend a lot of money on advertising, research and product development to achieve this growth.
As such, many growth companies are not profitable, and the ones that make profits end up reinvesting all the profits in the business instead of paying shareholders dividends. When inflation rises, the cost of funding growth companies increases.
This makes it more expensive to fund the desired growth and increases the risk that they might not achieve their goals. Value companies, on the other hand, like electricity and water companies, will still see revenues because users must pay their electricity bills.
High dividend-paying stocks also tend to suffer when inflation rises beyond a manageable level. As earlier explained, when inflation increases, companies earn more profits and can pay higher dividends. But when inflation is too high, profits fall, forcing companies to reduce the dividends they payout.
There is a minimal history of how cryptocurrency holds up in high inflationary periods. The oldest cryptocurrency (Bitcoin) is still a teenager (14 years old). Just last year, one of the top investment banks globally, JP Morgan, touted Bitcoin as the new inflation hedge, not gold.
However, considering the performance of the crypto market overall in 2022, it’s safe to say that cryptocurrencies behave similar to growth stocks and suffer more than stocks do when inflation rises.
How to Invest when Inflation is rising
The best bet is to have a diversified portfolio of different assets. Lower risk assets like cash and bonds tend to perform poorly when inflation rises, so seek out opportunities outside of those assets.
Assets like commodities, stocks and real estate tend to perform better in high inflationary periods. However, it’s essential to have a healthy balance of high and low-risk assets to protect the value of your investment. Because as we learned in this article, high inflation can lead to recessions, and high-risk assets don’t perform too well during recessions.
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