What is inflation and its impact on my investments?

Witnessing some inflation in the economy is actually a good thing as it means the economy is growing. But when inflation rises too much and for an extended period of time, its effects on the economy might result in losses for investors. 

Inflation is still high from the pandemic aftermath all around the world, around 10% in the European Union, 3% in Switzerland and 8% in the US, and even crazier, inflation has reached 85% in Turkey. This is actually the highest rate since 1980. High inflation can not be ignored as it can have large impacts on your wealth. 

That is why inflation is something that every investor needs to be aware of. By understanding how it works and how it can affect your investments, that is, by developing your financial literacy, you can make sure that your money is working hard for you. 

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What is inflation?

Inflation is defined as the rate at which the prices of goods and services increase over time. This means that each dollar you have today will buy less than it will in the future. For example, if the inflation rate is 2%, then a can of soup that costs $2 today will cost $2.04 in a year.

For inflation and other economic indicators, such as the CPI (Consumer Price Index), the US usually serves as reference. That is because the US has the biggest consumer market and Europe reacts usually 1 to 2 years later to what can be observed there, making the US a great predictor for Europe. Overall it can be said that if the US has a fever, everybody will get a cold.  High interest rates adopted by the Central Banks in response to high inflation are always a sign for an upcoming financial crisis. This is why everybody has to keep an eye on the US Fed rates, which are still rising.

If the European Central Bank decides to continue to raise its interest rates as a reaction to inflation, Switzerland will have to adapt as well and raise theirs. Ultimately, this would cause the Swiss franc to go up and Swiss exports to go down, both would have a terrible impact on the economy, and thus, on your portfolio. 

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How does inflation impact your investment?

In order to get a general idea of how inflation affects your investment, one must first understand the two types of inflation: flexible and sticky. Flexible inflation is typically caused by an increase in the prices of food and energy, while sticky inflation is linked to goods and services for which prices move more slowly. The main difference between these two types of inflation is that sticky inflation is much more resistant to change.

When it comes to investing, flexible inflation can cause your investment to lose value over time. In order to offset the effects of flexible inflation, it is important to invest in assets that are likely to go up in value along with inflation. For example, commodities like gold tend to do well when inflation is high. It is also crucial to take inflation expectations into account and keep an eye on issues such as the percentage increase in the cost of living.

Sticky inflation, on the other hand, can actually help your investment to grow over time. This is because sticky inflation is linked to an increase in wages, which means that people will have more money to spend, which is great for investments.

The following chart shows the evolution of sticky and flexible inflation from 1970 to 2022. Without surprise given the pandemic and global situation, flexible inflation has skyrocketed these past years, which is not great for investors. But on the other hand, as you can see at the end of 2022, sticky inflation has started to rise quite a lot, and this is a little more interesting for investors.

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What actually happens in your portfolio?

Inflation can have various impacts on your portfolio. For one thing, it can eat into the profits that you're hoping to make. Let's say you invested $1,000 in a stock that you expect to go up in value by 5% over the next year. If the inflation rate is also 5%, then the 5% increase in the stock price will just cancel out the 5% inflation.

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What can you do to protect your investments?

There are a few things you can do to protect your investments from inflation. You can decide to invest in assets that are likely to go up in value along with inflation. In the financial industry such assets are called “real assets”.For example, as said before, commodities like gold tend to do well when inflation is high. Another option is to invest in assets that generate income, such as rental properties. Indeed, income from these assets can help offset the negative effects of inflation.

Let’s summarize assets you should consider investing in when inflation is high:

• Stocks, prices of stocks might fall during the recession that follows episodes of inflation, and it might be a great investment opportunity, but you should differentiate growth from value stocks. Read more about share valuation;
• Real estate, because inflation is associated by rising interest rates, it is also associated to increased rents;
• Gold and commodities (e.g. oil or metals) usually offer a good protection against inflation in the long run.

The chart above shows the long term inflation adjusted return of stocks, bonds and gold since 1800. Long term, stocks are the best place to be to avoid that inflation.

In phases of inflation and rising yield, the bond allocation should be put to an absolute minimum. Also, to switch from long term bonds to short term bonds is recommended. 

Long term, inflation protected bonds are also a good investment. But be aware, it only makes sense to buy these bonds when inflation is low. Then they protect you from rising inflation. If inflation is high, inflation protected bonds are a bad investment.

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Growth vs value stocks

Historically, in the long run, stocks outperform gold and bonds when inflation hits. But before jumping head first in the stock market, it is important to differentiate growth and value stocks as they offer different returns in case of inflation.

Growth stocks are stocks of companies that are expected to grow at an above-average rate. This growth can come from a variety of sources, such as new products, expanding into new markets, or rapid growth in earnings.

Value stocks, on the other hand, are stocks of companies that are trading at a price below their intrinsic value. Intrinsic value is the inherent worth of a company, which is usually calculated by looking at its financial statements and growth potential.

So, which is better?

There is no simple answer to this question. Growth stocks tend to do well when the economy is expanding, while value stocks tend to do well when the economy is slowing down. 

In the case of inflation, value stocks will appear to be less volatile and more stable than growth stocks, making them a safer option to invest in.

This is mainly based on the fact that young growth companies are normally not yet profitable and take up loans to finance product developments and their rapid growth. In timestime of inflation and rising interest rates they get hurt double. Revenues shrink and finance costs are rising. This is the main reason for the strong collapse of growth stocks from November 2021 up to the time this article is written in December 2022.

In general, when central banks start to raise interest rates, it is a good time to invest in value, whereas if inflation and interest rates are low, growth is the place to be. Read more about how to invest in times of crisis.

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Stay informed

Investing is definitely not an easy task and inflation adds to the challenge. As always, you should consider your overall financial situation as well as your risk tolerance and your horizon before considering any investment. 

You should always keep an eye on the market, especially the US market, to try and get a feel of what is coming. We publish a weekly market report that takes into account all the current trends and important factors to take into account for your investments, make sure to subscribe! 

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