Inflation is a critical and cyclical macro indicator which influences actions from all economy participants, be it central banks, government policymakers, producers or consumers. Because of its far-reaching implications, even capital markets need to be attuned to the vast factors that could lead to changes in inflation over differing time horizons. At the very basic fundamental level, inflation also impacts returns that an investor earns on the investments he or she makes. Therefore, the concept of inflation-adjusted or real returns is important for all investors to comprehend. Put it simply, real return = nominal return less inflation.
For example, when a bank savings account gives a nominal return of 4 per cent per annum, the real return is negative because the last 12-months average inflation has been at ~6 per cent — much higher than the 4 per cent bank yield.
With that understanding now in place, let us look at how inflation impacts multiple asset classes.
Inflation impacts fixed income investments the most due to its inverse relationship with interest rates. As inflation inches higher, investors expected returns to also move higher to beat inflation. But as interest rates on debt instruments are fixed over their term, the prices of these instruments fall as investors sell the existing lower yielding products and move into higher yielding ones. So, in a rising inflation environment, fixed rate debt investments stand to lose the most. At times, central banks could take actions around monetary policy and systemic liquidity 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 to inflation which could be considered in times of rising inflation. Similarly, floating rate bonds could also be looked at in times of rising interest rates.
When it comes to equities, inflation can be good or bad depending on the level of inflation, nature of inflation (transient or persistent), the external macro environment, and each corporates’ sector exposure, balance sheet structure and pricing power. Low to moderate inflation at levels of 2-6 per cent is generally healthy for equities whereas hyperinflation of 10-14 per cent is bad. Rising raw material prices does pinch corporates operating margins, but if competitive dynamics enable the corporate to raise prices of its final products in-line, then it is said to have pricing power. In this case, the final consumer bears the brunt of inflation and the corporate maintains its margins. Capital markets reward such companies which gets reflected in rising stock prices. But if the demand is suppressed due to weaker consumer sentiments, high unemployment, sector disruption or any other reason, then corporates would find it difficult to pass on the raw material price rise to final product price hikes. This would lead to contraction in profits and consequent impact on stock prices.
Commodities are real, physical assets and a strong hedge against inflation as their prices define the underlying inflation. Their prices are an indicator of inflation to come. Inflation is a weighted index of prices of different goods and services – raw materials (wholesale inflation) and final products (consumer inflation) – combined in a basket. The proportion of these items is determined by the respective country’s government agencies. So, commodities (basic resources, metals, energy, agricultural produce) tend to do very well under a rising inflation scenario and vice versa.
The same relationship holds true for gold as well because it is also a precious metal – a commodity after all. Gold is the best inflation hedge as it tends to protect the value of your portfolio in times of rising inflation and hence it is also called a ‘premium store of value’. But if central banks raise interest rates under inflationary pressure, then non-yielding assets like gold could become relatively unattractive for some investors. The other attributes of gold that make it a valuable strategic asset in investment portfolios are – return-generating ability over long-periods, great diversifier due to its low correlation with other asset classes in both expansionary and recessionary periods leading to better risk-adjusted returns, liquid as other mainstream financial assets and no credit risk. Investors also look at gold as an ‘alternative currency’ or ‘currency of last resort’ especially in countries where local currency is losing value.
Property prices and rentals tend to rise when inflation rises as property owner or landlord demands higher returns to offset rising input and consumption costs. Thus, real estate is also a physical asset which has a high correlation with inflation. REITs and Real Estate 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, retail, or industrial property.
(Rajesh Cheruvu is Chief Investment Officer at Validus Wealth. Views are his own)