What is inflation?

Inflation is a state of rising prices for goods and services, and an important economic concept. This is an indication of the average change in prices paid by consumers for goods and services.

Inflation is always a part of economic life, although some periods witness greater or lesser inflation. Inflation influences many aspects of the economy, such as production, employment, consumer spending, interest rates, and investment. Because of its many effects, it is important to keep track of inflation and consider how inflation might affect a long-term investment strategy.

How inflation is measured

Since the late 1960s, most economies measure inflation using the Consumer Price Index (CPI). Inflation is measured and monitored by central banks and other organizations. CPI, or the Consumer Price Index, is a widely used measure of inflation that allows for comparability across countries. It measures the average of prices collected by surveying a basket of goods and services purchased by consumers.

It is often useful to compare the level of inflation to the rate of growth in wages, a measure known as "real wages". Real wages reflect the purchasing power of wages after taking the effects of inflation into consideration. It assesses how prices are affected by inflation, and provides a better indication of people’s purchasing power.

Other measures of inflation include the: • Producer/wholesale Price Index, which measures a specific range of goods • Commodity Price Index, which looks at the price levels and fluctuations for commodities such as oil, wheat, and metals • Gross Domestic Product deflator, which measures prices of all products and services produced in an economy

At times, inflation might exceed the amount expected by economists or investors. This is known as ‘excessive’ or ‘runaway’ inflation, and generally has serious consequences for economic activity and, ultimately, for long-term investment returns.

Why is there inflation?

Inflation is a result of market forces – chiefly the demand for and supply of goods and services. When the demand for goods and services increases faster than the capacity to supply them, then prices will begin to increase. Similarly, if the available supply of goods and services is low, prices will increase since there are more willing buyers than sellers.

Inflation is sometimes deliberately created by governments and central banks, in order to manage economic conditions. If the current outlook for production and employment is pessimistic, a government might attempt to stimulate activity by increasing the money supply and thus decreasing the value of each individual currency unit.

However, this policy carries serious risks, since inflation could get out of control and severely damage people’s savings. It can also reduce the incentive for firms to invest, since they will be presented with higher costs and unpredictable prices.

How inflation impacts investors

Inflation wreaks havoc on long-term investments. Inflation erodes the purchasing power of cash, and in turn affects the value of securities and assets held by investors. Since assets reflect the current economic climate, a rise in inflation can cause a decrease in their prices, decreasing the value of an investment portfolio.

It is, therefore, important that investors properly account for inflation when making an assessment of investment strategies, and be able to spot opportunities that arise in different periods. Investors must also aim to keep their investment portfolios well diversified, to minimise negative shocks related to any unexpected economic eruptions. Finally, investment funds and pension policies should be adequately indexed to reflect prevailing inflation rates, so that they are able to meet their stated objectives.

To understand why inflation is important for long-term investors, let’s look at an example. Say you bought a bond 20 years ago that paid 8% every year. Today, after taking inflation into account with a low 2% inflation rate, the purchasing power of those payments have likely dropped to around 6%. That’s a 25% drop in the real return of your investments.

Low inflation

At very low and consistent levels, inflation can be positive for investors. Inflation rates of up to 3%-4% are considered healthy for economic growth – particularly in a globalised economy with rapidly changing technology.

Periods of low inflation, such as during the latter half of the 20th century, offer ample opportunities for investors, as prices will remain relatively consistent, and economic inputs such as labour and capital far more easily absorbed by companies.

In this environment, more traditional methods of value investing will apply; where higher-than-average rates of return are achieved by simply purchasing securities and assets at a value below what they are expected to realise in future market prices. This will require a thorough understanding of the economic system in which an investment is being made, so as to appropriately adjust for the impact of inflation on the returns from an asset.

Alternatively, investors might consider targeting poorly performing securities, that have been undervalued by the markets. These securities have been forced to suffer prolonged bouts of underperformance, offering attractive opportunities for profit for the more enterprising investor.

High Inflation

Any inflation rate above 5% is commonly considered to be higher than average. In countries with CPI-inflation rates in the double digits, or even triple digits, this might develop into a severe case of hyperinflation that cause significant damage to economic systems.

Research by the World Bank suggests that at a certain point, the cumulative effect of prolonged high or hyperinflation can be devastating, leading to a significant fall in economic output and purchasing power of citizens. They analysed 40 different cases of inflation rates exceeding 20% for more than a month, and came to the following conclusions:

• High and hyperinflation had a major economic impact • Inflation had long-lasting effects after it had ended, suppressing economic output even in periods of low inflation • Countries had difficulty restoring their economic output and purchasing power, nearly eight years after the inflation had ended

On the other hand, periods of higher-than-average inflation – commonly referred to as hyperinflation – generally occur when an economy has expanded significantly in a short space of time and consequently has experienced a sharp fall in the value of its own currency.

When making investments in hyperinflationary climates, investors might consider betting against the inflation, by buying assets that offer returns in currencies other than the local currency. This ensures that whilst money invested will suffer from depreciation, any returns generated from investments made will maintain their value over the long-term.

When investing in hyperinflationary economies, investors might either invest directly in assets offered in the these economies, or if the payment is made in a foreign currency, in broadly diversified, index funds. This approach will ensure that returns are generated in a currency that is not affected by local economic uncertainty and hence is less prone to significant drops in value.

How to protect yourself against inflation

Inflation is a reality of economic systems, and should always be taken into account when investing for the long-term. Whether investors are faced with low or higher-than-average rates of inflation, understanding the impacts of each and making suitable adjustments to investment plans can help to protect against the variable effects of inflation, and thus help secure long-term investment profits.

The underlying logic of investing with inflation in mind is easy to understand; there is no point in securing short-term gains if returns are eroded by inflation over the long-term. Hence, diversification and flexibility are the two primary strategies to protect against the unexpected effects of unexpected inflation.

When investing in extreme periods of inflation, investors would also do well to bet against the local currencies, and secure returns in foreign, more stable currencies – something that will further reduce the effects of prices set in politically or economically uncertain climates.

Investors should also keep mindful of the fact that returning to normal levels of growth and inflation can take time, meaning they should be wary of investing in assets from countries facing extreme inflation, and add additional diversification to their portfolio as insurance from potential losses.

Asset classes and inflation

Investors should be mindful that different asset classes may perform differently over different periods of inflation.

In low inflationary periods, investors can adopt a conservative approach and focus on low risk opportunities such as bonds or income-generating stocks. This will help protect against losses in purchasing power, and will enable investors to preserve or grow the purchasing power of their assets against future inflation.

In addition, investors looking to build an all-weather portfolio should consider a diversified mix of assets, such as stocks, bonds, commodities and real estate. All these asset classes have performed differently during times of low, moderate and high inflation, and should be included as part of an well-diversified portfolio.

According to a research study published in the Journal of Financial and Quantitative Analysis, commodities are the best-performers in periods of high inflation. This is because their intrinsic value does not suffer from inflation in the same way other assets do, and so they serve as an effective hedge against inflation. For example, when gold prices spike due to inflation, and stocks prices take a hit as investors fear more inflation.

Real estate, too, has proven to be resilient in times of inflation, with land and property values typically increasing over time. This is because most property prices are driven by a finite supply and ever-increasing demand, both of which are not affected during times of inflation. This makes them an attractive asset class for hedge against inflation.

Finally, stocks, while potentially volatile, are smart investments during periods of low to moderate inflation. They offer investors a high potential for returns, and are proven to outpace deflationary environments and outperform bonds in low inflationary environments.

Investors should take consider expanding their portfolio if faced with extreme inflation, as the focus should be on capital preservation and hedging against risk. Building a portfolio of assets that can perform well across different economic climates is the best way to protect a long-term investment from the damaging effects of inflation. With the proper research and understanding of the roles of different asset classes in times of inflation, investors will be able to make the best decisions when navigating rising inflation.

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