This update should not be taken as advice. If you are unsure about any of the content please contact your financial adviser. Please remember that the value of stock market investments will fluctuate and investors may not get back the original amount invested. To assist, where appropriate, a glossary explaining some of the terms used has been provided at the end of this update.
I usually write these notes around the end of each month and try to discuss topics that you might find interesting, or at least, that I find interesting. Inevitably, for the last year, rising inflation has been a constant theme. Therefore, I thought it might be worth writing a note specifically on the subject, as it is front and centre of our lives at present. It will impact your investments and your life.
Where did it come from?
If I were to look back further in time at these notes, I have little doubt that inflation was mentioned a few times as a likely outcome of the economic support packages provided by governments and central banks though the pandemic. At the time, let’s not forget, it would have been seen as a “price worth paying” to ward off a debilitating recession.
As we rebounded from the COVID induced downturn, inflationary pressures increased and were turbo charged by the jump in oil and gas prices a year ago as supplies were interrupted; you will remember the queues at petrol stations. It wasn’t just petrol, there were supply chain shortages in many industries as companies couldn’t meet the rapid jump in demand post COVID; McDonald’s even ran out of milk shakes. The impact is simple; lack of supply means prices rise which is inflationary.
The problem was exacerbated by the invasion of Ukraine by Russia, which had an immediate impact on the supply and price of energy, food and many other goods.
Inflation had arrived; quickly and aggressively.
There are other reasons for inflation to head upwards; strong economic growth or big wage increases that stimulate demand for goods and services have the same effect.
Is inflation itself a bad thing?
In itself; no.
In fact, a modest level of inflation is a good thing. It helps economic growth, it allows companies to increase the price of their products, which allows for wage increases.
Rising house prices generate wealth and spending in the economy. In fact, central banks and governments (policy makers) around the world target a low level of inflation; the US central bank targets an annual increase of 2% in the Consumer Price Index (CPI), the most commonly used measure of inflation.
Maybe a better way to look at it is to consider deflation; falling prices or CPI. This has the opposite effect; reducing demand and slowing economic growth, possibly leading to recession or worse, depression. Some inflation is good.
Is too much inflation a bad thing?
Simply, prices can rise steeply and quickly, meaning your ability to purchase the same level of goods and services is negatively impacted and your standard of living will fall. Furthermore, as a result, it is likely that reduced demand will lead to the providers of goods and services experiencing less demand, which can lead to falling profitability and rising unemployment.
What can be done about it?
The simple answer is; there are not many options.
Sharply rising inflation will decrease by itself over time, as its negative impacts are self-mitigating. However, policy makers, correctly, fear the medium to long term damage it does and change policy to dampen inflation and get it back down to levels that are a positive for the economy and our standard of living.
The most important tool is to put interest rates up. The impact of that is twofold. Firstly, it encourages saving of cash, as the return you will receive rises and secondly, it discourages borrowing, as the cost of borrowing rises. Taking on debt and investing it stimulates growth. Companies do this to make more profits and individuals may do so to buy properties or investments.
The problem is that interest rates are a blunt tool. There is no way of knowing how much inflation will fall by if there is an increase in interest rates of, for example, 0.5% furthermore, there is a lag effect; the day that the increase takes place does not mean that spending or investment decisions change that day. It would be normal to consider the impact and also ponder what might be coming next.
What is the impact of rising inflation and therefore rising interest rates?
It means that the returns from cash savings improve and the cost of borrowing rises.
That second point is the most important one. As you will know, if you have a variable rate mortgage, the cost of your mortgage will rise, as will the interest rate on new fixed rate mortgages, and that is likely to have a negative impact on house prices. If you rent, it is likely to feed through there as well, as the costs for the landlord have risen. But it has huge ramifications throughout the economy.
Companies often borrow money to invest in machinery or research or new product promotion, amongst many other things. If the cost rises, that is less likely to happen; growth prospects worsen and employment prospects would as well.
In other words, the outlook for the economy and our standard of living softens. Rising interest rates imply slowing economic activity and wealth generation.
What does that mean for my investments?
That depends on the type of investment.
If it is bonds, those issued by governments or companies, it is likely to be negative. Rising inflation means that the future monetary value of the bond is reduced. Furthermore, bonds typically pay a fixed rate of interest; as the interest on cash deposits rises, the attraction of investing in bonds falls.
For company shares (equities) the risk is that profits will fall as demand for their products falls. Therefore, stock markets are at risk. Real estate, as noted above, could come under pressure. You might expect commodity prices such as oil, gas, metals and agricultural products to be negatively impacted as well, as demand falls. However, while gold is often seen as a safe haven in periods of rising inflation,it hasn’t been this time!
Inflation is at highs not seen for decades, interest rates are going up and the outlook is bleak. Should I be selling my investments?
That is not a decision I can or would make for you.
But I can tell you that financial markets take into account what has happened, but more importantly, what it is thought will happen. In other words they discount expectations for the future, including what might happen to inflation and interest rates. Therefore, unless things turn out worse than expected, the prices of different types of assets reflect the outlook.
I don’t know the answer, but asset prices have fallen so far that, it seems to me, that there is a lot of bad news already taken into account, particularly in bond markets.
Central banks will keep putting interest rates up until inflation is beaten. They have decided that the risk of recession is the lesser of two evils; inflation being the greater. For what it’s worth, I agree with them.
And never forget; it’s an economic and financial cycle, it always has been. It goes up, it goes down and it goes up again. Investments should be for the long term, throughout the cycle, not for a part of the cycle.