High Inflation – Bad for Investing?
We all know inflation leaves less money in our pockets. The cost of food has gone up 3-5% in 20211, which has hit some harder than others depending on what they frequently purchase; shelter, fuel – it all adds up to higher costs and less disposable income.
If inflation has a negative impact on us, why do governments target an inflation rate of 2% in North America?2 They have found that 2% is the optimal level of inflation which provides economic stability. The reverse of inflation is deflation demonstrated in a shrinking economy where wages and costs are going down. Ideally, for the government, we would have some inflation…but not too much.
Recently, the news has talked about how inflation is too high (estimated 2021 – 3.15%). When inflation is too high, governments often increase interest rates to bring inflation under control. If inflation is not brought under control, there are potential negative effects on various investments options.
Affects of increasing inflation on investments:
- Bonds – An increase in interest rates results in lower prices for bonds. Money Managers prefer to buy new bond issues with higher interest rates so current bond holders will need to lower their sale price to get investors interested in buying their lower interest bond.
- Stocks – Inflation affects stocks in several ways:
- First, if a company has high debt, their cost of borrowing will go up leading to lower profits and lower share prices.
- Second, if new increased bond rates start to compete for stock returns, investors may sell their stocks and move to bonds
- Third, if governments are trying to cool the economy by increasing interest rates, companies will not be growing their revenues as quickly and investors may move their money to other safer options.
- Real estate – The affect of inflation on real estate can be like stocks but the impact may not be as noticeable because of the potential challenge in selling real estate in a tight market.
- First, in high inflation environment rents go up, which can be good unless your property is in an area with rent controls.
- Second, real estate prices will tend to go up over time with inflation. There can be a downward price pressure if mortgage rates go up too quickly and people don’t qualify for the same value of home due to a decreased principal capacity.
- If interest rates jump significantly and you have a large mortgage, when you need to renew your mortgage the increase in your payments can have a significant impact on what is left of your income for other things.
This article is a simplistic discussion of the effects of inflation on investments. There are many other variables that must be taken into consideration such as:
- Supply and Demand: If a company sells a product that has limited supply, prices can go up at a rate faster than inflation. This can increase a company’s profitability, which usually results in higher share prices.
- A company’s ability to thrive in a high interest rate environment: If they have low debt levels and a product that they can raise prices equal to or faster than inflation, then company profits will increase, which also can result in higher share prices.
- Government intervention: Printing money, increase/lower taxes, raise/lower interest rates, increase/decrease capital expenditures, etc. All these things can have an impact on investment performance.
An economy with increasing inflation produces changes in investment strategies for bonds, stocks, real estate, and the bottom line for daily living. At Connect Wealth, we are here to provide sound financial advice to clients to help navigate this challenging environment.
References:
1Canada’s Food Price Report 2021
2Why does the Federal Reserve aim for inflation of 2% over the longer run?
