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Inflation refers to the rate at which the general level of prices for goods and services rises, causing purchasing power to fall. Essentially, when inflation is high, each unit of currency buys fewer goods and services. This has a broad impact on investments in several ways:
The real return on an investment is the return after adjusting for inflation. For instance, if you earn a 7% return on an investment in a year with 3% inflation, the real return is only about 4%. So, while the nominal (or stated) return might seem high, the actual purchasing power derived from the investment might be substantially lower.
Bonds and other fixed-income securities pay a fixed rate of return, which can be severely impacted by inflation. If inflation is high, the real value or purchasing power of the interest payments can be eroded. Furthermore, when inflation is expected to rise, interest rates often rise in tandem, leading to falling bond prices.
Historically, stocks have been viewed as a hedge against inflation because companies can raise prices for goods and services, potentially leading to increased profits. However, the relationship isn't so straightforward. High inflation can increase input costs for businesses, and if they can't pass those onto consumers, it can hurt profits. The real returns of equities can also be affected by inflation, but they may fare better than fixed-income securities.
Inflation can impact exchange rates. If a country has high inflation relative to others, its currency might depreciate. This can affect the returns of foreign investments for investors who trade their investments back into their home currency.
Central banks often raise interest rates to combat high inflation. Higher interest rates can make borrowing more expensive and can lead to decreased spending and investment in the economy. This can impact the profitability of businesses and, consequently, asset prices. As of the time of this publication, interest rates are at a 22-year high.
The expectation of future inflation can influence investor behavior. If investors expect high inflation, they might demand higher returns to compensate for the loss of purchasing power, which can impact asset valuations and interest rates.
Inflation can influence the cost of capital for businesses. When inflation and interest rates are high, the cost to borrow increases. This can reduce corporate investment and impact the growth potential of businesses.
For investors who receive periodic payouts, such as coupon payments from bonds, there's a risk that they might have to reinvest these proceeds at lower rates if inflation is high and interest rates fall in the future.
Retirement & Long-Term Planning
Over long periods, even low rates of inflation can substantially erode purchasing power. For retirees or those planning for retirement, inflation is a key consideration. The value of future cash flows, like pension or annuity payments, might be much less in real terms due to inflation.
Inflation is considered a deep risk, as it poses a permanent loss of real capital. See the below exhibit for an illustration of how the purchasing power of $1.00 shrank to $0.05 from 1945 to 2022.
Exhibit 1: Inflation-Adjusted Value of a U.S. Dollar, 1945-2022, Source: U.S. Bureau of Labor Statistics
For investors, understanding inflation is crucial as it plays a significant role in determining the real return on investments. Diversification across various asset classes and geographies can be one strategy to manage inflation risks.
Reach out to Chicago Partners to set up an introductory meeting with one of our financial advisors who can help you get started on your diversification strategy.
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