For example, when a bank savings account gives a nominal return of 4% per year, the real return is negative because the average inflation for the last 12 months has been around 6%, which is much higher than the return. banking 4%. .
With that understanding now in place, let’s take a look at how inflation affects multiple asset classes.
Inflation affects fixed income investments the most because of its inverse relationship to interest rates. As inflation rises, investors expected yields to rise as well to beat inflation. But because the interest rates on debt instruments are fixed over their term, the prices of these instruments fall as investors sell existing low-yielding products and switch to higher-yielding products. Thus, in an environment of rising inflation, investments in fixed-rate debt lose the most. Sometimes central banks might take monetary policy and systemic liquidity actions to manage interest rates or yields on debt products, but eventually fundamentals would catch up. Inflation-protected securities are a category of bonds that adjust yields for inflation, which could be taken into account during times of rising inflation. Likewise, floating rate bonds could also be considered in times of rising interest rates.
Regarding equities, inflation can be good or bad depending on the level of inflation, the nature of inflation (transient or persistent), the external macro environment and sector exposure of each company, the structure balance sheet and pricing power. Low to moderate inflation at levels of 2-6% is generally healthy for stocks while hyperinflation of 10-14% is bad. Rising commodity prices reduce companies’ operating margins, but if competitive dynamics allow the company to increase the prices of its end products online, it is said to have pricing power. . In this case, the end consumer bears the brunt of inflation and the company maintains its margins. The capital markets reward these companies, which is reflected in the rise in stock prices. But if demand is suppressed due to weakening consumers, high unemployment, industry disruption, or any other reason, then companies would find it difficult to pass on higher commodity prices. on increases in the prices of final products. This would lead to a contraction in earnings and a consequent impact on stock prices.
Commodities are real physical assets and a strong hedge against inflation because their prices define core inflation. Their prices are an indicator of future inflation. Inflation is a weighted index of the prices of different goods and services – commodities (wholesale inflation) and finished products (consumer inflation) – combined in a basket. The proportion of these items is determined by government agencies in the country concerned. Thus, commodities (basic resources, metals, energy, agricultural products) tend to perform very well in a scenario of rising inflation and vice versa.
The same relationship also applies to gold, because it is also a precious metal – a commodity after all. Gold is the best hedge against inflation as it tends to protect the value of your portfolio in times of rising inflation and is therefore also referred to as “premium store of value”. But if central banks raise interest rates under the pressure of inflation, non-performing assets like gold could become relatively unattractive to some investors. Other attributes of gold that make it a valuable strategic asset in investment portfolios are: the ability to generate returns over long periods, high diversification due to its low correlation with other asset classes in boom and bust periods leading to better risk-adjusted returns, liquid like other traditional financial assets and without credit risk. Investors also view gold as an “alternative currency” or “currency of last resort”, especially in countries where the local currency is losing value.
Real estate prices and rents tend to rise when inflation rises, as the owner or owner of real estate demands higher returns to offset rising costs of inputs and consumption. Thus, real estate is also a physical asset which has a strong correlation with inflation. Real estate REITs and ETFs invest in a pool of real estate assets and are a better way to gain exposure to this asset class rather than investing in tangible physical land, residential, commercial, commercial or industrial properties.
(Rajesh Cheruvu is Chief Investment Officer at Validus Wealth. His views are his own)