Inflation is the rate at which prices of goods and services rise or fall across the economy. It affects everything from the cost of living to the cost of business. Higher prices make it harder for consumers to spend if average earnings don’t rise in line with inflation. And if companies have to increase wages, it can hit profits and, consequently, share prices. So inflation significantly impacts both the economy and financial markets.
In May 2016, annual UK Consumer Price Index (CPI) inflation was at 0.3%, but it has since risen sharply and is now above the 2% target set by the Bank of England (BoE), for the first time since the end of 2013. The consensus view is that it will continue to climb in 2017. A higher oil price and President Donald Trump’s reflationary growth policies also look set to boost inflation globally.
Meanwhile UK interest rates remain at historic lows. What this means for cash savers is a significant erosion of their savings pots. But what does it mean for investors?
Inflation and stocks
The impact of inflation on equity returns can be quite corrosive. For example, assume a portfolio of shares delivered an average annual return of 5%. If inflation was running at 2%, this would mean the portfolio would only deliver a real return of 3%, offering a much less significant boost to an investor’s purchasing power.
Inflation can eat away not only capital growth, but also the value of dividend payments, which will not usually keep pace with rising inflation. Investors who are taking income from their investments can use the rate of inflation as a guide to how much their portfolios need to return for them to maintain their standard of living.
The impact on stocks may also depend on whether inflation is expected or unexpected and, when inflation is high or the outlook is uncertain, market volatility may be higher. The commodities market can give some insight into the future direction of inflation.
Investors can mitigate some of the effects of inflation with careful stock selection. During periods of high inflation, value stocks tend to perform better while, during periods of low inflation or deflation, growth stocks are more likely to do well.
Generally speaking, quality companies with pricing power tend to do better in an inflationary environment because they can pass on higher costs to customers who consider their products essential. Food and beverage retailers, pharmaceutical brands, tobacco, utilities and energy companies may fall into this category.
Inflation and bonds
Central banks can raise interest rates as one way of controlling rising inflation. Higher interest rates mean lower bond prices, so a bond portfolio becomes worth less to the investor who owns it. The fixed income a bond pays out will also have less purchasing power. So inflation can reduce the bond’s principal and interest payments.
Many governments use inflation as a tool to shrink their national debt pile — this is the case with inflation-linked bonds, which they can issue as a way to reduce their borrowing costs.
Inflation-linked (also called index-linked) bonds aim to mitigate the effects of rising prices by targeting a real return above the rate of inflation. 'Index linkers', as they are nicknamed, link the bond’s interest payments and principal to an inflation measure such as the Retail Price Index (RPI) so that the bond’s principal rises in line with retail prices.
Floating rate notes can also look attractive in this environment because the issuer can change the interest rate so the bond’s return keeps pace with inflation.
Another option for investors is to turn to high yield bonds in niche areas of the market as the higher yields on offer can mitigate the effects of inflation, although this usually means taking on more credit risk.
There are some assets which are commonly considered to act as hedges against inflation. Usually these are real assets such as gold, oil, natural gas, or land which are seen as a store of wealth. The prices of these assets tend to be inversely correlated to equities and bonds, meaning they typically move in the opposite direction.
Property can also act as a hedge if the owner can raise rents as inflation rises but, on the other hand, if inflation is combined with rising interest rates, this can push up mortgage rates, reducing capital gains.