The Bank of England targets an inflation rate of 2% per year. Moderate inflation signals that everything is ticking along as it should and that the economy is growing at a reasonable pace.
As the economy is cyclical, we were already heading for a period of higher inflation. However, the perfect storm of Covid, Brexit, the energy crisis, and now the Russian invasion of Ukraine, has moved up the timeline and pushed prices to concerning levels.
Energy is a particular factor, as the cost of heating and powering a home will take a significant chunk out of any household budget. As businesses face rising costs, prices are expected to increase across the board.
When you invest, it’s worth understanding how the different phases of the economic cycle will affect your portfolio and your financial plan in general.
The Impact of High Inflation
When inflation reaches high levels, this can start a vicious cycle:
- As prices rise, wages and benefits may struggle to keep up with the costs. This can push many households into relative poverty.
- Businesses are under pressure to increase salaries, but may also be facing higher costs for energy and supplies. They either need to increase prices (adding to the inflationary concerns) or cut back.
- Some businesses won’t survive, which contributes to rising unemployment and poverty.
- This increases the strain on public finances as more people may be reliant on benefits.
- The economy can slip into a recession.
- The government may elect to increase interest rates to curb excessive inflation. This aims to discourage spending and borrowing, and reward saving. However, it is a balancing act, as an overly tight monetary policy can restrict economic growth.
How Investments Are Affected
The various asset classes are affected differently by inflation. The main effects are explained below.
Equities
Traditionally, investing in equities offers the best chance of beating inflation. But there are some caveats to this:
- The companies you invest in will not be immune to the effects of inflation. Rising costs could affect their profitability.
- Periods of economic uncertainty can cause equity markets to become volatile.
- When inflation is high, investors tend to seek out steady, dividend-producing ‘value’ stocks. Established financial institutions and the oil and gas industry tend to perform well during these periods.
- In contrast, investors tend to pull away from growth stocks, such as those in the technology sector. These companies tend to reinvest their profits in the expansion of the company. This can result in high capital returns (as we saw throughout 2020), but dividends are often sparse.
Bonds
Bonds are sensitive to inflation, both in terms of the price and the dividend yield.
- When inflation is high, or predicted to increase, newly issued bonds need to produce a higher yield to encourage demand.
- Existing bonds may fall in price as investors seek out higher-yielding investments. This can cause a portfolio holding bonds to drop in value.
- High inflation usually precedes an increase in interest rates. This can also discourage bond investing, as it can become more worthwhile to keep money in the bank.
- Buying bonds on the second-hand market can become appealing, as the yield is fixed. When prices drop, the yield becomes more attractive in percentage terms.
- Investors are more likely to seek out bond investments during periods of market volatility. This can help to cushion some of the swings in the equity market.
Property
While property is slower to react to economic forces, the market is not immune to inflationary pressure.
- Periods of high inflation can cause property prices to increase. This can lead to buyers being priced out of the market.
- Rents are likely to rise as the cost of living increases.
- Increasing interest rates can make it more expensive and difficult to borrow. This can reduce demand for property, which in turn, leads values to fall.
- Property is not a liquid asset and can be difficult to sell, particularly during times of market turbulence or a recession.
Cash
While it can be tempting to keep more money in cash when things are uncertain, there are still some risks involved.
- Interest rates on cash rarely exceed inflation. This means that your money will actually be losing value in real terms year on year.
- However, interest rates will usually increase when inflation is high, which means that any money you do need to hold in cash (for example, your emergency reserve or short-term savings) should benefit from a better return.
How to Invest
The strategies for investing during periods of high inflation are the same as at any other time:
- The key is to invest in a wide range of assets. Equities and bonds, value and growth stocks, small cap and large cap companies will all behave differently during different phases of the economic cycle. As we can’t predict exactly how this will play out, holding a wide selection allows you to benefit from the upside, while protecting your capital from the worst of the volatility.
- Take an appropriate amount of risk. If you can cope with the ups and downs, and have a long investment timeframe, a portfolio holding mainly equities offers the best chance of exceeding inflation over the longer term. This can be balanced out with cash, property, and bonds depending on your goals and risk appetite.
- Avoid trying to time the market. We can’t predict the high and low points, and getting it wrong can be costly. Most of the returns achieved by an equity portfolio are made over a few strong trading days throughout the year. If you sell investments during a downturn, you won’t see the benefits of the recovery.
- Avoid expensive investments or hotly tipped stocks. These rarely outperform the market over the longer term.
- Keep up with regular investments and consider investing more if this is in line with your goals. Pound cost averaging means that you benefit from growth when the markets rise, and from cheaper shares when the markets fall.
- Consider working with a financial adviser. As well as recommending the most appropriate investments, an adviser will provide an objective view and help you avoid emotional investment decisions.
There are many good reasons to invest in stocks. You may wish to consider investing more, but only if this aligns with your financial plan and your goals. A strong financial strategy aims for consistency throughout market turbulence, and you shouldn’t change your plans every time the wind changes.
Please don’t hesitate to contact a member of the team to find out more about your investment options.
