What does higher inflation do to your savings and investments?
December 19, 2021
8 minutes to read
1. What is inflation?
You’ll already have noticed it when you buy things, and in the news headlines. Everything is getting more expensive. This is actually what inflation is all about: an increase in the average price level of goods and services.
Inflation is measured using a price index. That’s a basket with thousands of products and services. And every month the price of all these goods and services is tracked: from the price of a packet of semi-skimmed milk to a hearing aid, from the price of a taxi ride to a shoe repair.
This allows us to see how much more expensive life has become compared to the previous month, or perhaps a year ago.
2. Is inflation useful?
Inflation of 2% is considered a good target in the euro zone. The fact that we want to make everything 2% more expensive every year seems pretty crazy at first glance. Because this is how we lose purchasing power: we could buy 100 donuts with 100 euros a year ago, but now we can only buy 98 donuts for 100 euros if the inflation rate is 2%.
Nevertheless, inflation is quite useful. Among other things, it makes people want to do something with their money to avoid it losing its purchasing power. For example, they might renovate their homes because it is more expensive to postpone doing it. Or they invest. This way, money keeps circulating and the economy can grow. And more growth can lead to more prosperity. In order to keep moving forwards, it is therefore better to accept a bit of inflation. Not too little, nor too much either.
3. Why is inflation high at the moment?
In October 2021, annual inflation was 4.16% in Belgium. If you paid 100 euro for your shopping cart in October 2020, you would pay 104.16 euro for exactly the same shopping cart in October 2021. We are seeing this high inflation not only in Belgium, but also across the entire euro zone. Indeed, in all major economies. There are a number of reasons, which interact, for why inflation has been higher for several months now:
- supply chain issues, which are making some goods scarcer
- shortages of raw materials due to high demand
- strong economic growth, rising consumption and, on average, greater disposable household wealth
- higher oil and energy prices
- massive support measures from governments and central banks
- a low base for year-on-year comparison (2020 was a crisis year)
Many economists and the major central banks are working on the assumption that this high peak of inflation is temporary. But the general consensus is that inflation likely will remain higher than it was before the outbreak of the coronavirus crisis.
4. Stagflation, deflation, ... what exactly are these?
If inflation occurs at a time of low economic growth, or even a shrinking economy, this is referred to as stagflation.
If the rate of inflation falls, or in other words the rate of price increases slows down, this is referred to as disinflation.
The reverse of inflation is called either deflation or negative inflation. With deflation, the average price level of goods and services is actually falling.
Reflation means that inflation is returning after a period of deflation.
Hyperinflation is extremely strong inflation: a screwdriver costs EUR 10 now and EUR 20 next week.
5. What does inflation do to savings?
If the interest rate on your savings account is 2.5% and inflation is 2%, you won't notice much. Your savings retain their purchasing power and you earn a little extra on top.
If the interest on your savings account is 0.5%, and inflation is 2%, then you will begin to notice it. In this case, your savings will be losing their purchasing power. The good news is that your EUR 100 has become EUR 100.50 after one year. However, despite the fact that you became richer by EUR 0.50, you can now buy less than you could a year ago.
In practice, savings are currently losing a lot of purchasing power: inflation is quite high, while since 2016 most regulated savings accounts have only paid 0.11% interest.
6. What does inflation do to bonds?
Inflation is only one of the forces that influences the price movements of bonds, shares and other assets. Interest-rate policy and monetary policy, investor sentiment and fiscal, political and economic developments also affect the price levels. Context is therefore important.
Investors generally tend to buy bonds because they want a stable income stream in the form of coupons. However, as the interest rate on most bonds remains unchanged until their maturity, the purchasing power of the coupons paid decreases as inflation increases. As a result, bond prices tend to fall as inflation increases. Riskier high yield bonds tend to yield higher coupons and thus have a better buffer than investment-grade bonds if inflation rises.
As a rule, most bonds will therefore fall in value, with the exception of inflation-linked bonds such as TIPS (Treasury Inflation-Protected Securities), a type of sovereign bond issued by the US government. Because both the principal and the coupons increase if inflation rises, they offer instant protection against rising inflation.
7. What does inflation do to equities?
There are different opinions on this, and context is equally important.
In theory, equities should hold up better against inflation than bonds. After all, a company’s earnings and profits should rise at the same rate as inflation. This means that the price of shares should rise in line with the general rise in prices of goods and services. Unfortunately, the reality is not this black and white.
Higher inflation also makes it more expensive for companies to borrow. At the same time, raw materials and labour are becoming more expensive just as consumers’ purchasing power is diminishing. But what is probably most important in the present market conditions is that higher inflation lowers expectations of earnings growth, which in theory will then put pressure on share prices (although there is little sign of this for the time being).
Of course, equity investors anticipate a certain level of inflation each year, and therefore adjust the expected return to cover the expected inflation. For example, if investors are expecting a return of around 5% per annum after inflation (including dividends), and inflation is 2% per annum, investors then expect a return of around 7% per annum, including inflation.
But if inflation suddenly shoots up from 2% to 4%, investors are not exactly happy about this. This is because they will now expect a higher return to offset the new, higher risk. Instead of a return of 7%, investors may demand a return of 9%. Share prices are then likely to fall.
At company level, two characteristics are valuable if inflation increases:
- the company’s ability to raise prices easily (even when demand is flat and capacity is not fully utilised), without fearing any significant loss of market share.
- the ability to cope with large increases in volume with only minor new capital investments.
Companies that incorporate both of these characteristics will generally perform well in times of increased inflation. Technology, pharmaceuticals, food and beverages, tobacco and household products, among others, are often well-armed in the face of rising inflation. Cars, energy, transport and utilities are less well placed. Not only are these companies often capital intensive, but in many cases their margins are not large enough to offset changes.