As the world started to emerge from the COVID-19 pandemic, supply shortages and rising demand pushed the cost of many products higher. The price of lumber alone jumped 250% from March 2020 to April 20211. Now, if you were repairing an aging fence or putting an addition on your house, you’d certainly understand how rising prices can affect the everyday cost of living. But what effect does inflation have on your finances? The short answer: it can pose a “stealth” threat as it relentlessly eats away at your savings and investment income. To help you understand more, in this article we’ll look at what inflation is, what causes it and the potential impact on your finances.
1 Source: National Association of Homebuilders
Inflation – silently eroding your purchasing power
Simply put, the inflation rate refers to the pace at which the cost of goods and services increase over time. An increase in inflation can be caused by many things, including supply shortages and rising demand like we saw with lumber. Or it may be a sharp rise in production costs, including raw material and wages. These rising costs are often passed on to consumers. For example, when the price of oil rises there is an almost immediate increase at the gas pump.
To calculate Canada’s inflation rate, Statistics Canada created the Consumer Price Index (CPI). It assesses the cost of over 700 products every month, including food, clothing, housing and education. The components of the CPI constantly fluctuate. And in the 41-year-period from June, 1980 to June, 2021 Canada’s average annual inflation rate was 2.89%1. Or perhaps more aptly, as the Bank of Canada (BoC) puts it, the value of money fell by 2.89% annually.
This means, on average, something that costs $100 this year would cost $102.89 the next year. Sure, if you’re working, your wages may rise to keep pace with inflation. But if you’re retired and on a fixed income your purchasing power (the amount of goods and services you can purchase) declines steadily over time.
INFLATION AND YOUR PURCHASING POWER*
Source Sun Life Global Investments. Inflation rates used are hypothetical*.
1Source: Bank of Canada Inflation Calculator
Inflation and bond investments
We’ve looked at how inflation erodes your purchasing power. But how will your investments hold up to inflation? The short answer? It depends on what investments you’re holding.
Let’s start with bonds, and how they react to inflation. Among the most widely held bonds, are those issued by governments. These are high quality and backed by a low default rate. Hence, they are called investment grade bonds, and must carry a BBB credit rating or better.
These bonds are owned for both the income they produce and their lower risk profile. To that end, they are often held by institutions, pension plans and investment managers to lower risk in their portfolios. For example, traditionally, to offset the risk inherent in equites, a balanced mutual fund would hold 40% in bonds and 60% in stocks.
Nevertheless, returns on bonds can be negatively affected by inflation in a couple of ways. First, depending on the interest rate, if you received an annual payment of $200 a year on your bond, you would be able to buy less and less each year with it. Secondly, these bonds can be hurt when interest rates rise. This may occur when inflation is running above the BoC’s 2% inflation target. To slow inflation, it could force the bank to raise its key lending rate.
It sounds counterintuitive, but when interest rates rise bond prices fall. Bonds with longer maturity dates (such as a 20-year bond) are particularly vulnerable to rising rates. Why is this? Let’s say your 20-year, $10,000 bond comes with coupon rate of 5% - the coupon rate is the annual income you can expect to receive. The problem is if interest rates jump, new 20-year bond issues coming to market might have a higher coupon rate. If so, new buyers would obviously opt for the higher coupon. This in effect would reduce your bond's value with it now selling at a discounted price.
Alternatively, there are classes of bonds that are indexed to inflation. Two of the most widely held, include floating rate bonds and treasury inflation-protected securities (TIPS).
Unlike most bonds that have a fixed interest rate, these types of bonds carry a variable coupon rate. For example, the interest rate on a floating rate bond is tied to a benchmark rate, such as the U.S. Federal Reserve’s key overnight rate. When the Fed rate rises, so will the interest paid on a floating rate bond. This is why, with today’s low interest rates expected to rise over time, floating rate bonds are seen as being attractive.
Inflation and stock portfolios
Like bonds, the impact of inflation in your stock portfolio depends on how it is invested. Let’s begin by looking at dividend-paying stocks, a source of income for many investors. They are usually paid on a quarterly basis, from a company’s cash flow or profits. And often range from 1 to 10%.
How are dividend payouts affected by inflation? Some companies, such as a utility, may perform well in an inflationary environment because they can pass rising costs on to consumers. This allows them to increase their dividend payouts. For example, if inflation is running at 3%, and a company increases its dividend to 5% you could come out ahead.
The opposite would be true if rising costs triggered by inflation force a company to cut its dividend. So again, how inflation affects dividend income comes down to what dividend-paying stocks are included in a portfolio. That’s why dividend fund managers put great effort into analyzing a company before they invest. They want to determine whether the dividend being paid is sustainable and whether it may increase over time.
Inflation affects growth and value stocks differently
Growth and value investing are two common styles of investing. To understand why inflation affects these stocks differently, remember that inflation erodes the value of money over time. The important issue then is over what time frame is a company’s profitability being calculated. Or more succinctly: profits today could be worth more than potential inflation-eroded profits in the future.
Let’s begin with value stocks. By definition, these stocks trade at a discount to the market. However, when buying a value stock the investment manager believes there is a reason that a company might return to, or increase profitability. And the manager anticipates that this may occur over a comparatively short period of time.
With growth stocks, the opposite is often true. In this case, the investment manager may buy a growth company like Apple that is forecasting profits well into the future. Or it may be a company with strong cash flows, even though it could be losing money or have low profits. The assumption being that it might be profitable at some point in the future.
As a result, when inflation and interest rates rise, growth stocks tend to fall. This is because the present value of future earnings is being discounted at a higher rate of inflation.
With the low inflation rate we’ve seen in recent years, growth stocks have consistently outperformed value stocks. In investing, however, past performance is not an indication of future performance. And as the world began to emerge from the pandemic, at one point we saw inflation rise, value stocks gain and growth stocks retreat.
Inflation hedges: commodities, gold and property
As we’ve noted, what is held in a portfolio will go a long way to determining how it stands up to inflation. To that end, when inflation is rising, investment managers may invest in companies such as a utility. Or it could be a company manufacturing an essential product and can pass rising costs on to consumers.
They may also invest in specific asset classes, including commodities, real estate and precious metals. These have traditionally performed well in an inflationary environment. For example, the Canada Pension Plan is broadly diversified. At the end of March 2021, it held 21% of its $497 billion portfolio in what it terms real assets, including real estate, infrastructure, energy and resources2.
2 www.cppinvestments.com Fiscal 2021 annual report
Real estate investment trusts (REITs), which trade like equities, have traditionally been seen as an option to hedge inflation. This is because physical assets such as a house often grow with or above the rate of inflation. This, in part because supply often outstrips demand for both personal and rental use. Moreover, if an individual buys a house at a fixed interest rate, inflation becomes an ally. This is because as wages rise with inflation, the fixed cost of the loan becomes more manageable.
As the demand for such things as housing rises, the price of commodities that go into it, like lumber, also increases. The price of copper is illustrative. It rose 90% from May, 2020 to May 2021, in part on the rising demand for housing and electric vehicles3.
3Source: Market Insider
Precious metals like gold and silver are also seen as stores of value during periods of high inflation or economic upheaval. In addition, they are used in sophisticated manufacturing processes where they currently can’t be replaced. This also causes them to rise with inflation and to potentially protect your purchasing power.
Offsetting inflation requires a plan
As we’ve shown here, inflation can erode your purchasing power. But as we’ve also noted, it’s what’s in a portfolio that matters when inflation increases. That’s why the best advice is to meet with a financial advisor. They have the ability assess your finances and suggest strategies that may help offset the risk that inflation poses.
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