Inflation is a bugbear – there are no two ways about it.
According to the International Monetary Fund (IMF), inflation is defined as follows: “Inflation measures how much more expensive the set of goods and services has become over a certain period, usually a year.”
Rising prices are central to the definition of inflation. To combat these pressures on the economy, central banks use a variety of measures, notably quantitative tightening, to rein in runaway prices.
Increasing interest rates is one of many powerful tools available to the monetary authorities. By raising the price of borrowed money, it’s possible to disrupt the velocity flow of money through the economy.
But there are downsides, especially regarding how interest rates affect stocks. People spend less when there is a high cost associated with using money.
Federal Reserve Bank members can steer monetary policy committees toward increasing the bank rate. This has a twofold effect on the economy:
- Savings can increase because the yield on savings rises, and
- Borrowing tends to slow down because the cost of capital is more expensive.
Of course, inflation is measured according to prices for a broad ‘basket’ of goods and services, notably mortgages, rentals, and housing expenses.
The CPI (consumer price index) reflects consumption patterns in the economy. It represents the average cost of purchases.
With so much price fluctuation in the economy daily, it’s tough to gauge an effective measure of price increases. As a rule, low rates of inflation are preferred for investment activity.
Indeed, the Fed, the Bank of England, and other monetary authorities have targeted a 2 per cent inflation rate as the ideal goal. Currently, the US is experiencing 8.52 per cent inflation – way off target.
Why does inflation affect stocks, commodities, indices, currencies?
Inflation is one of the most powerful forces affecting global financial markets.
Inflation directly impacts many economic indicators, including disposable income, consumer confidence, and spending levels, which affect asset prices. One way to mitigate this is by investing in Australian stocks, which can provide stability in volatile times.
Below are five investment options that have proved lucrative during inflationary periods:
1. Gold
The price of gold increases when there’s inflation in the economy. Gold is a haven investment because it protects against inflationary pressures.
Gold bullion bars (one-ounce ingots) and coins are highly liquid investments, especially when purchased from trustworthy and well-known gold dealers. They’re also portable, so you can take them with you if you need to leave the country in a hurry. They’re also portable, so you can take them with you if you need to leave the country in a hurry. If you need quick cash, you can easily sell gold.
Indeed, central banks across the globe hold large reserves of gold bullion as part of their foreign currency reserves portfolio.
For example, you can buy gold through an exchange-traded fund or store physical bullion at home or in a safety deposit box at your bank. However, this isn’t without risk – as with any precious metal stored at home, there’s always a chance it could be stolen, so insurance cover is essential to protect your investment from theft and other risks such as fire damage.
One way to mitigate these risks is by buying allocated (segregated) storage where each bar or coin has its serial number and certificate of authenticity detailing weight and purity. This option gives investors much greater peace of mind that their precious metals are being stored safely off-site away from prying eyes.
In addition, the London Bullion Market Association sets the daily spot price for gold trading worldwide (the LBMA price). This serves as an international reference point for pricing contracts worldwide, including central banks and refiners, who trade large quantities daily – typically millions of dollars’ worth per transaction.
Overall demand for gold tends to increase when paper money becomes worthless due to high inflation rates. For example, in Zimbabwe in 2008, hyperinflation reached 500 billion per cent per month, resulting in people carrying wheelbarrows full of cash just to buy basic groceries. A single US dollar note would cost several hundred million Zimbabwean dollars, making even small purchases prohibitively expensive before stores ultimately ran out, forcing people into barter systems where goods were exchanged instead, such as one chicken for two loaves of bread.
2. Hedged equity funds
A hedged equity mutual fund employs various hedging techniques insulating investors somewhat from stock market volatility caused by rising interest rates during inflationary periods.
For instance, higher interest rates usually lead to lower stock prices because they make borrowing more expensive. This slows down economic growth while simultaneously increasing costs associated with holding inventory (costs go up faster than revenue).
Hedge funds employ various strategies designed to mitigate some downside risk while still providing upside potential. This includes, but is not limited to, short-selling stocks they believe will fall in value along with using derivatives.
These include call options where they gain exposure or ownership rights over underlying assets like stocks without actually having any ownership stake. This limits the downside loss potential while still benefiting should share prices rise as expected.
Hedged equity funds offer protection against unforeseen events should share prices unexpectedly fall instead, resulting in losses on their short positions.
These aren’t covered by gains made on corresponding long positions elsewhere within the same portfolio. This means that overall losses could potentially be incurred despite initially being profitable had everything gone according to plan.
Some hedge funds use leverage. This affords managers greater flexibility when executing trades. However, this comes hand-in-hand with increased risk compared to non-leveraged vehicles.
Recall that debt creates additional risks beyond those inherent within equity securities, thus adding another layer of complexity into already complex portfolios.
Leverage amplifies both gains and losses, so it pays dividends knowing how this strategy works before getting involved. Remember that traders and investors could potentially incur heavy losses quite easily otherwise.
3. I-series government bonds
I-series bonds are an inflation-linked investment that can prove especially useful during inflationary times.
The principal is adjusted according to the Consumer Price Index (CPI), providing some protection against inflationary pressures.
In essence, these bonds are designed to keep pace with rising prices in the economy – meaning you’ll always have purchasing power.
4. Commodities
The price of commodities such as oil, corn and wheat increase during high inflation. This is because it costs more to produce goods when raw materials become more expensive.
You can trade commodities on futures exchanges worldwide, such as the Chicago Mercantile Exchange (CME).
You can also buy commodity-linked ETFs, which track a basket of assets, including oil, gold, and silver.
This enables you to benefit from exposure without having any ownership stake in underlying assets themselves. Commodities limit downside loss potential while still providing upside if share prices rise as expected.
5. Real estate
Real estate tends to appreciate during periods of high inflation.
This is because there’s less money available for people to buy homes and commercial property when interest rates go up, making mortgages more expensive, therefore slowing down economic growth while simultaneously increasing costs associated with holding inventory (costs go up faster than revenue).
When demand decreases relative to supply, prices usually increase, all else remaining equal.
Naturally, there are other factors influencing real estate values, including but not limited to:
- Financing terms
- Local economies
- Job creation/loss
- Infrastructure spending
- Trends population growth
- Environmental regulations
- Zoning restrictions availability
- Prevailing market conditions
- Prevailing interest rates amount
These are just some of the best investments during inflationary times. Of course, it is recommended that you consult with a financial advisor before making any decisions about your investments to ensure you are making the right choice for your circumstances.