Inflation has risen substantially in over 44 countries within the last two years. In the United States alone, the inflation rate has increased over four times the amount between the first quarter of 2020 and the first quarter of 2022. Inflation rates have generally been much higher in 2022, an acceleration that has not been seen in the U.S. for several decades. Inflation makes it difficult for consumers, businesses, and investors to prioritize spending when basic necessities such as rent, food, clothes and gas are much more expensive.
With higher prices, your money doesn’t go as far, particularly on investments producing fixed returns, like bonds and savings accounts. The threat of higher interest rates can also make it difficult for you to see a steady cash flow from your investments. In this post, we’ll cover which investments are generally affected by periods of increased inflation and how adding different investments to diversify your portfolio can help with resiliency in periods of economic decline.
What Is Inflation?
Inflation is a term used to define the rise in the prices of goods and services in the economy, which erodes purchasing power over time for consumers and businesses. The decreasing rate of purchasing power is often reflected in the average price increase of specific goods.
To best understand inflation, you can compare a commonly used item’s current price with its price from a few years or decades ago. For example, in the U.S., the average cost of a burger in 1978 was about $0.64. In 2022, that $0.64 would have the same buying power as $3.03. For $3 in the 70s, you could’ve bought almost five burgers versus only one in 2022.
Inflation isn’t limited to a specific item or service. Inflation impacts prices across all sectors of the economy and can affect each sector differently.
What Causes Inflation?
Several factors can cause inflation, such as:
- Demand-pull inflation: When there’s a higher demand for goods but not enough means to increase supply, prices increase as businesses cannot scale their production fast enough. Some economists describe this as “too many dollars chasing too few goods.”
- Cost-push inflation: When labor and raw materials cost more for businesses, they raise the price of the goods and services they offer, which leads to higher inflation rates. This is also known as wage-push inflation.
- Devaluation: If a currency, such as the U.S. dollar, loses value compared to other currencies, it can make importing goods and materials more expensive, causing businesses to raise prices to cover the increased expenses and result in inflation.
- Rising wages: As workers earn more money, they have a more expendable income and are willing to pay more for goods and services. This usually causes increased demand and leads businesses to raise prices to cover labor costs and higher production.
Shocks to our typical economic systems, such as a pandemic, can influence market behavior in unpredictable ways. Economists also review the way corporations and companies price goods and record profits during periods of inflation to evaluate how the market is functioning.
How Does Inflation Affect Investments?
A higher rate of inflation can negatively impact various investments, including stocks and bonds. The rate of inflation will determine how quickly the real value of an investment is eroded and how much purchasing power is lost at a certain point in time. Investors typically buy bonds or treasuries with fixed interest rates that remain the same, and the longer that rate is locked in, the more vulnerable the price is to inflation changes over time. As a result, some fixed-income investment prices tend to fall as inflation rises.
3 Investments Impacted by Inflation
Because inflation can quickly become a widespread issue across many or all sectors of the economy, it’s critical for investors to know which investments have been historically impacted by inflation rates and to avoid them until prices decrease.
1. Long-Term Bonds
As we briefly mentioned above, inflation can negatively affect your investment bonds, particularly long-term, fixed-income government bonds. Bonds are subject to interest rate risk. Bond prices are inversely related to interest rates, which means as interest rates rise, the prices of a bond will fall, and vice-versa. The real face value of bonds is also eroded by inflation, especially in longer-maturity debts. For instance, if a long-term bond pays a 4% yield and inflation has a 3% rate, the real rate return of the bond becomes 1%. This is pure buying power for investors since their bond pays a fixed coupon which translates into a fixed dollar amount.
Essentially, the higher the interest rate, the lower the bond price, and the higher the bond’s yield will rise across the yield curve. This is because bond prices and yields move in opposite directions, so investors will demand a higher yield to combat inflation. Ultimately, the way bonds are structured can mean a lower value for your long-term, fixed-income investment.
Inflation and higher interest rates can significantly impact other fixed-income financial assets and decrease the value of certain assets and commodities. Because interest payments on existing fixed-income assets tend to be less competitive compared to newer, high-rate assets, the prices of the existing assets will usually decline
The inverse relationship between fixed-income asset prices and interest rates can become a headache for investors during economic troubles like inflationary periods. High prices and inflation rates can also reduce the returns on many financial assets that rely on fixed payments, such as bonds, making it even more difficult to improve cash flow. If you still want to invest but want to take some risk off the table, diversifying your assets and investment portfolio may help you maintain a steadier cash flow during volatile times.
2. Small-Cap Stocks
Small-cap stocks are the stocks of companies that have a lower market capitalization. As a result, these stocks tend to be more economically sensitive and, therefore, could be affected more by an economic downswing. During inflation, where prices are higher and some goods and materials are scarce, small caps are subject to significant inflows and outflows, which can create a period of uncertainty for your investment.
Since small-cap stocks are usually more economically vulnerable and present a riskier ride for investors, they tend to do worse when there are external pressures, such as rising prices and decreased value, upon the economy. Though some small-cap stocks may be more dynamic and adapt to changes more quickly than some large-cap stocks, most companies will experience some form of this impact during an inflationary period.
Generally, investing in small-cap stocks may not be your best short-term bet until inflation declines, which is when they tend to perform much better, as is primarily true for all companies.
3. Large-Cap Stocks
As with small-cap stocks, large-cap stock investments have the potential to be risky during inflation. Because large-cap stocks do not necessarily increase with inflation, they may not be ideal for investors who want a quick buy-and-sell transaction.
While large-cap stocks may be less volatile than other stocks, they can still experience periods of high volatility, which means investors can’t assume their money is entirely stable. Lastly, large-cap investments are unlikely to outperform the stock market regularly because of their “slow and steady” characteristics. This means the dividend value is more likely to be eroded by inflation.
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At 1031 Crowdfunding, we want to support real estate investors by guiding them through their investment goals and giving them more flexibility to reinvest in various real estate endeavors and diversify their portfolios. If you’re unsure of your future in investment, our team of experts can assist you in making better-informed decisions that suit your needs. We invite you to register for an account today to learn more about your options or visit our education center online for more information.
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