As the global economy begins to recover from the impact of Covid-19 it’s inflation rises that are starting to worry investors.
Whilst steady moderate inflation is associated with economic growth, rapidly rising inflation could mean the economy overheats.
This could mean bad news for equities and bonds.
So how should we combat inflation rises?
What happens when inflation rises
As a reminder inflation is the rise in prices of the goods and services we buy.
As an economy grows the demand for goods and services outstrips supply and therefore businesses increase their prices.
Inflation is the silent killer when it comes to your money and actually one of the biggest long term risks you face. Far more dangerous than the volatility of the global equity market.
You see, if you want your money to grow over time or even retain its purchasing power it must at least grow by the rate of inflation.
For example if you received 2% interest from the bank on your cash savings but inflation was 3%, you have actually lost 1% in real terms.
Recently, the UK has seen inflation (as measured by the Consumer Price Index – CPI) rise to 2.5%, the highest rate in nearly 3 years.
Over in the US inflation hit a 13 year high of 5.4%.
Rapid inflation rises can be bad for both equities and bonds and as you are likely to have some mix of the two you may see your investment portfolio suffer.
Most bonds offer a fixed level of interest for a set period. At the end of the period you also get the capital you invested in the bond back. As the interest is fixed at the start, if inflation rises above the level of interest you’re getting then this will reduce the returns from the bond. Your original capital has also lost its purchasing power over the years you have held the bond.
Equities tend to perform well vs inflation over the long term. This is because the great companies of the world can usually raise their prices to offset the increased cost of the materials they need.
However in the short term if inflation rises rapidly then this could cause uncertainty about the economy and could eventually lead to central banks raising interest rates to combat it.
Equity markets don’t generally like higher interest rates as it makes it harder for businesses to borrow money, they face extra costs serving their debts and investors pull out of stocks for the safety of higher interest returns on cash.
So what to do when inflation rises?
First of all, it’s not entirely certain that we will see a period of high inflation. The Bank of England have said they expect to see inflation rises above 3% in the coming months but that this is ‘transitionary’.
Thankfully, high periods of inflation are not that common throughout history. Instead inflation tends to rise steadily.
Roughly, you might see 1 or 2 high periods of inflation every 10 years.
Traditionally commodity prices have tended to rise during periods of high inflation as the demand for materials grows. Investing in things like gold, oil and other raw materials can allow you to benefit from high inflation.
But the difficulty is choosing which commodity is best as not all commodities perform well in all inflation environments. A basket/fund of commodities could be a better option.
The problem with investing in commodities however is that they don’t tend to perform that well when inflation is low.
So it goes back to trying to time the market again and therefore it might not be worth trying to change your portfolio to combat inflation rises when high inflation rises are not that common.
It’s like all things linked to the world economy, everything goes in cycles. The business cycle of recession to growth tends to happen roughly every 10 years and you are likely to see 1 or 2 bad years in the stock market every 10 years.
Working on this basis another more easier way to combat inflation over the long term is to invest in global equities and bonds. This means investing more globally rather than having a high allocation to your home country like the UK.
By investing globally you will be investing into different countries that are at different stages of the economic cycle and therefore wont all have inflationary pressures. You are therefore spreading your risk.
Here at RTS Financial Planning we run a selection of low cost globally diversified portfolios that use over one hundred years of economic data to combat all sorts of economic conditions.
Want to look under the bonnet of how we invest? Please contact us for a free, no obligation chat. We’ll even have a quick look at your own portfolio and give our thoughts.
Stock market linked investments and any income from them, can fall as well as rise and is not guaranteed. Any figures quoted are for illustrative purposes and should not be taken as a forecast or guarantee. Past performance should not be seen as an indication of future returns and clients may get back less than they have invested.