You may have been hearing the word ‘inflation’ a lot lately and feeling the impacts of it too. You may find yourself paying more for everyday expenses these days, such as gas, groceries and maybe even rent. In the euro area, in January 2022 inflation was 5.1%, whereas it was just 0.9% in January 2021. Other parts of the world are feeling inflation too. In the US, inflation climbed to 7.5% in January 2022, its largest 12-month increase since 1982.
But what does inflation mean for you as an investor? And what exactly is it?
Investing during times of high inflation
If you leave your money under your mattress or in a bank during high inflation, its value will decrease. Inflation can also impact your investments, depending on the type. Take bonds, for example. Depending on the type, you may be receiving regular coupon payments of €5, which will stay the same until maturity. However, when inflation comes into play, the €5 coupon you were receiving is now worth less than before. The same goes for the principal amount. At maturity, this will also be worth less than before inflation. Some bonds are inflation-linked, which can help protect investors from inflation.
Investing in stocks can help protect against inflation. But again, some more than others. For example, companies with pricing power may perform better during high inflation. Companies with pricing power can raise prices easily when production costs rise without negatively impacting profit margins.
Historically, some asset classes have also generally fared better in inflationary times than others. Commodities, for example, typically see price increases when inflation is rising. Same with real estate. Inflation and house prices tend to move in the same direction in the long term.
When investing during times of high inflation, you mustn't overreact. Just because inflation is high now doesn’t mean it will last forever. Consider your investment plan before making any investment decision to ensure it aligns with your goals and risk tolerance.
What is inflation?
We’ve all heard the word ‘inflation’ but may not know what it actually means. Keeping it simple, inflation is the increase in prices over time. For example, the British Beer & Pub Association reports that the average cost of a pint of beer in 2000 was £1.90, whereas it was £3.59 in 2020 in the UK. That is inflation. Inflation results in a decrease in purchasing power, meaning that it takes more units of currency to purchase the same goods and services than it did in periods prior.
How is inflation measured?
Inflation is measured differently all over the world and many metrics are used. For example, in the euro area, the Harmonised Index of Consumer Prices (HIPC) is the main metric to measure inflation. It is calculated based on a ‘shopping basket’ containing goods and services, such as food, clothes, train tickets, housing rent and more. This metric is ‘harmonised’ as it includes all countries in the euro area. But that’s just for the euro area. In the US, for example, the Consumer Price Index (CPI) is used to measure inflation, and in the UK, it is measured with its version of the CPI.
What causes inflation
The causes of inflation can be generally broken down into two categories, cost-push inflation and demand-pull inflation.
- Demand-pull: This is caused by a strong increase in demand for a product or service, causing prices to rise. Demand-pull inflation can arise due to, for example, due to overall economic growth, rising inflation rates and technological innovations.
- Cost-push: This occurs when prices increase when the prices of materials and wages go up. In this case, demand typically remains unchanged, but since production costs have increased, supply declines. The added costs are passed on to consumers in the form of higher prices for the finished goods. Some of the main causes of cost-push inflation are increased labor costs, increased taxes and scarcity of raw materials.
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The information in this article is not written for advisory purposes, nor does it intend to recommend any investments. Please be aware that facts may have changed since the article was originally written. Investing involves risks. You can lose (a part of) your deposit. We advise you to only invest in financial products that match your knowledge and experience.
Sources: Reuters, British Beer & Pub Association, Pimco, Seeking Alpha, Investopedia