5 ways inflation impacts your investments
Here’s what you should do about it
There is a war on and they say that, in war, it is important to know your enemy. Yes, I could be discussing Ukraine/russia here, but this is an investment column and the enemy today in the investment world is not tanks, but inflation.
This enemy has likely destroyed part of your investment portfolio this year, especially if you own any growth stocks. It has attacked your wallet every time you fill the car up with gas or buy anything at all. Now, it has indirectly raised your mortgage payments, since rising interest rates are the specific weapon governments use to combat this foe. The enemy has been quiet for 30 years, but has made its new attack with strength.
It’s important to understand what you are dealing with. Let’s look at five characteristics of inflation and its impact on the investment world. A knowledgeable defender is a strong defender. Get to your battle stations. Interest rates are a slow weapon against inflation Interest rates have already started to rise in both Canada and the United States and many more rate hikes are expected. But investors worried about inflation need to understand interest rates have a lag effect. It can take from six to nine months for higher rates to begin to have any impact on the economy and inflation.
Thus, there are two important considerations here.
One, inflation may stay high, or even move higher, after the first few interest rate hikes. It is important not to panic if this occurs. Two, investors will look forward and there could be lots of sector rotation ahead of any actual change in inflation if investors believe the enemy can be defeated. It’s possible that all the sectors that are working today, specifically energy and materials, might see some selling in a few months, even though the headline inflation numbers might still be high.
INFLATION EXPECTATIONS ARE MUCH MORE IMPORTANT THAN REPORTED INFLATION
I recently bought a new car and the salesman indicated I should close the deal before March 31, because Honda was implementing its “highest price increase ever” on April 1. The dealership at closing was an absolute zoo. Buyers everywhere were desperately trying to buy before prices went up.
This, for the uninitiated, is how inflation takes root. Consumers fear inflation, so they start spending their money fast. This incremental demand itself pushes prices higher and we start an upward inflationary spiral: higher prices create more demand, which itself creates higher prices. The lesson here on the enemy: perhaps investors should pay just as much attention to prices at the stores they frequent and/or what their neighbours and friends are doing, as they do to what the U.S. Federal Reserve or the Bank of Canada are up to.
Stocks do not always decline in times of inflation This point really needs to be underscored because investors right now are in full sell-almost-everything mode due to higher inflation. But stocks do not need to suffer from inflation. Some companies, such as those in industrials and health care, have some pricing power. And some sectors, like materials and energy, can significantly benefit from inflation.
Overall, stocks have averaged annual returns about eight per cent in historical times of inflation and higher interest rates (the big exception was in the mid 1970s). Not great compared to some years — such as 2021, but eight per cent is hardly a disaster. Yet, you would never guess at this history based on how much selling we have seen in equities markets this year.
Higher prices are the best cure for high prices Consumers only have so much disposable income. If it costs you $50 more to fill up your gas tank, that’s $50 less you have to spend in a restaurant. Higher prices — eventually — do result in fading demand. This is how recessions can start: higher prices, less demand, less production, less employment, less demand, lower prices. Of course, some products are less sensitive to higher prices. Products such as medicine and cellphones are
typically seen as price inelastic. But plenty of industries will see demand slowly fade as they raise prices. This can result in steep margin compression and lower earnings as sales falter (but input costs do not). The lesson for investors: be cautious of those companies selling high-margin, non-essential products.
DIVERSIFICATION REMAINS ONE OF THE BEST STRATEGIES TO FIGHT THE ENEMY
As noted, inflation is not always bad for stocks. Diversification will help you fight the enemy, though. For example, energy stocks surged this year and last. Investors who decided in 2020 that they didn’t need any energy exposure have likely seriously underperformed in the past year. Same thing with metals and gold. These did nothing for years, but now many sector stocks have doubled or tripled, offsetting the market pain elsewhere. Unless your name is Kreskin and you can predict the future, it is better to just stay diversified. Having exposure to all market sectors gives you the best chance of having some winners in your portfolio — in all market cycles.
Peter Hodson, CFA, is founder and head of Research at 5i Research Inc., an independent investment research network helping doit-yourself investors reach their investment goals. He is also portfolio manager for the i2i Long/short U.S. Equity Fund. (5i Research staff do not own Canadian stocks. i2i Long/ Short Fund may own non-canadian stocks mentioned.