What investors need to know about inflation
In June, I received a “Remember When …” birthday booklet, which, by way of images and fun facts, transported me to the year 1980. There was a particular page that caught my eye: The Cost of Living in 1980. A fixed “basket” of consumer goods that cost you $100 then would cost you $322.10 today.
Inflation, in simple terms, is a rise in prices. It was staggering to see how little some basic goods cost back then, even though rising prices are expected over time, and a moderate level of inflation is good for the economy.
The recent increase in inflation is the result of pentup demand stemming from coronavirus lockdowns and supply chain disruptions. The Bank of Canada targets inflation between one and three per cent, and aims to hit the midpoint of two per cent, but the Consumer Price Index (CPI) rose 3.1 per cent on a year-over-year basis in June, down from a 3.6 per cent gain in May.
Inflation, of course, affects more than just the price of things. It also affects average investors, including their portfolios and retirement plans.
Right now, you’ll notice you’re paying more for consumer goods, such as gas, cars, clothing, furniture, and groceries. If your income doesn’t keep pace with rising inflation, your standard of living will be impacted since your income can’t afford as much as it used to. Inflation also impacts workers with fixed wages and pensioners who live on a fixed income.
Central Banks use monetary policy, such as managing the supply of money into the system and moderating interest rates, to stimulate the economy and bring consumption forward. The intended or unintended consequences of such policy decisions can also inflate financial assets. If central banks leave interest rates too low for too long, the result will potentially be higher inflation.
According to the Bank of Canada, the recent increase in inflation is temporary and many analysts agree the increase will be transitory. Prices are rising quickly, but we are still far off the inflation levels we had in the early 1980s. The rate of inflation in Canada in 1980 was 10 per cent and rose to 12.5 per cent in 1981.
How does inflation impact your portfolio?
My colleague, Rob Edel, chief investment officer at Nicola Wealth, recently wrote that, according to the Bank of America, institutional investors see inflation as one of the market’s biggest risks.
Incremental inflation growth can be good, but rising interest rates impact real yields, bringing them down. The concern is that central banks will eventually have to raise rates if inflation starts to increase. On a company level, if businesses are not able to pass on price increases, their margins will decline. Some companies and sectors fare better than others in an inflationary environment. For the market in general, if inflation and yields exceed a certain level, valuations are impacted due to the discount rate of future cash flows.
The best way to protect your investment assets is to hold a highly diversified portfolio. Different asset classes will be impacted by inflation in different ways. Identify opportunities with exposure to multiple asset classes, such as private income-producing real estate, infrastructure, and gold, all which are historically a hedge against inflation.
Edel also advises that financial stocks, such as banks, tend to outperform as inflation pushes interest rates higher and the yield curve steepens, making their lending portfolios more profitable. Given financials are also considered value stocks, it should come as no surprise that value also outperforms in line with higher inflation.
How does inflation impact your retirement plan?
Inflation impacts your purchasing power and should be built into every retirement plan. If your annual retirement income goal is $100,000 after tax in today’s dollars, you will require $150,000 after tax in 20 years to maintain the same purchasing power, assuming an inflation rate of two per cent. Your retirement plan
INCREMENTAL INFLATION GROWTH CAN BE GOOD, BUT RISING INTEREST RATES IMPACT REAL YIELDS, BRINGING THEM DOWN.
should target a real rate of return (your portfolio rate of return minus inflation), ensuring you maintain purchasing power.
Old Age Security (OAS) and Canada Pension Plan (CPP) are increased to keep pace with the cost of living, as measured by the Consumer Price Index. OAS is reviewed quarterly in January, April, July and October, while CPP is reviewed once per year with adjustments made in January.
Most economists see inflation rising moderately, and believe the current spike will be fleeting, while a smaller contingent sees a more meaningful and lasting increase. Currently, the markets appear to believe the former, but it’s good to be prepared just in case they’re wrong.