The sustained, broad and quick rise in prices of goods and services, is seriously eroding purchasing power. A nation’s goal is to maintain a small but positive inflation rate that is economically useful. High inflation impairs long-term economic performance, as it tends to feed on itself. This phenomenon reminds me of the Ouroboros, which is often used as a metaphor for the financial alchemy driving the bear market in fear. Because, as consumers spend more and save less due to high inflation, the velocity of money increases in the market further boosting inflation and contributing to inflationary phycology.
Consider, what inflation is. Inflation measures the rate at which the purchasing power of money erodes over time. As money acts as a store of value, money’s purchasing power is wholly dependent on price levels. Therefore, as prices increase, each unit of money becomes increasingly less valuable – eroding its purchasing power.
How Inflation Affects Asset Values
Assets with fixed, long-term cash flows tend to perform poorly when inflation is rising, since the purchasing power of those future cashflows falls over time. Conversely, commodities and assets with adjustable cashflows (eg. property rental income), tend to perform better with rising inflation and are often used as an inflation hedge. Let’s take an in-depth look at the effects of inflation per these loosely categorised asset classes.
A. Impact of Inflation on Share Prices
The relation between inflation and share price is quite complex on an ordinary day. Recent economic times have been heavily muddied by recently past performance since the onset of the pandemic. Keep in mind that the NSE has been named the third worst-performing stock market on the continent since January. And, if you hold shares, you’ve most definitely felt a bearish trend. The flight of foreign investors and ease of repatriation in the recent past have resulted in the continued fall in stock prices.
However, this cannot be compared to the effect inflation may have on the share price on the stock exchange. So, let’s take a look at the long-term and short-term perspectives of the impact of inflation on stock prices.
Inflation and Stocks in the Short Run
Short-run dynamics are the least favourable as the relationship between equity prices and inflation will have a negative correlation. As inflation rises, stock prices fall and vice versa. This adverse effect of inflation on stock prices in the short term could result from a range of factors such as falling short-term revenue, general economic slowdown and/or lowered or even negative returns decreasing demand for equity investments.
Inflation and Stocks in the Long Run
The current inflation rates, despite government indicators, have become so high eroding purchasing power
So will inflation hurt stock returns in the long run? The current state of the economy may have you considering changing your investment strategy.
Learn more: 7 Timeless Ways to Protect Your Finances Against Inflation
B. Impact of Inflation on Debt Securities
Inflation is very damaging to fixed-rate debt securities as it devalues the interest rate payments and principal repayments. If inflation exceeds the interest rate, investors are in effect losing money after adjusting for inflation. Therefore, as an investor you should:
- Focus on the real interest rate which is derived by subtracting the inflation rate from the money interest rate.
- Ensure that your fixed income portfolio is built for rising rates. Long-term fixed-rate debt is more vulnerable to inflation than short-term debt because the effect of inflation on the value of repayments is correspondingly greater, and compounds over time.
- Seek to invest in assets that perform best under inflation. Go for investments that bring in more cash during times of rising inflation or rise in value as inflation increases.
C. Impact of Inflation on Real Estate
Although real estate continues to be a popular choice as a store of value amid inflation, it isn’t completely infallible to rising interest rates and financial crises. Keep in mind that the increase of interest rates is a conventional monetary policy response to rising inflation. So who knows how far our current state of inflation will last? And, how changing monetary policy will move our economy?
This, however, doesn’t completely take away from the merits of investing in real estate. It is still a great store of value while still generating increased rental income amid inflation. So, investors have the choice to either purchase real estate directly or invest in it by buying shares of a real estate investment trust (REIT).
Learn more: How to Profit With Real Estate Regardless of The Economy
D. Impact of Inflation on Commodities
Whenever there is a rise in inflation, investors tend to turn to tangible assets that are likely to rise in value. For centuries, investors have turned to gold and other precious metals – causing the price to rise as inflation rises. Other commodities that have been considered include oil, copper, wheat, cotton and more – which tend to rise in inflationary environments.
If you’d like to purchase gold, you can get it directly from a bullion or con dealer or indirectly by investing in a mutual find or exchange-traded fund (EFT) that owns gold. In Kenya, we have the option to purchase the Absa New Gold ETF. The Absa New Gold ETF has been trading at an all-time high.
Sophisticated investors also have the option to trade commodities futures or the shares of producers, in advanced markets.
How Inflation Affects Savings
The high inflation rates we are currently experiencing are quickly eroding the value of your savings faster than ever.
Let’s say you have Ksh. 100,000 in a savings account that pays a 5% interest rate. After a year, you will have Ksh. 105,000 in your account. But if the rate of inflation is running at 7%, you would need Ksh. 107,000 to have the same buying power that you started with. Therefore, as much as you have gained, you are losing buying power at the same time. So, anytime your savings do not grow at the same rate as inflation, you will effectively lose money.
The overall quick rise in prices today is reducing the purchasing power of consumers, since a fixed amount of money will afford progressively less consumption now, and even less in the future.
So how can you assess the impact of inflation on your savings?
The Rule of 72
A simple way to measure the long-term effects of inflation on your savings is the “rule of 72”. Typically, we use this rule to approximate how many years it will take an investor to double their money at a certain interest rate.
Here’s how it works: Divide 72 by the annual interest rate to determine the amount of time it takes for an investment to double.
For example, money invested in a mutual fund yielding 10% a year would double in a little over 7 years, according to the rule. One with a 7% annual return would do so in approximately 10 years.
How to Plan Ahead
Despite the persistent increase in the cost of goods, we can always take assurance that our government will at least make efforts to keep inflation in check. As investors, we need to avoid panicking and avoid emotion-based decision-making. Rather, look to preserve portfolio worth from the effects of rising inflation and preserve your buying power. And, diversify your holdings. Hedge for inflation and replace equity exposure with strong assets that can weather any economic storms with ease. For instance, consider businesses with less reliance on raw materials or interest-rate-sensitive stocks. Any rise in costs or interest rates will increase operating costs for the company.
Image Credits: Top by Anna Nekrashevich