Currently, inflation is more of an annoyance than the economic tyrant of old. Given the unprecedented stimulus that the global economy has received since the coronavirus crisis hit, the debate is whether these “whatever it takes” financial packages will stoke a sustained period of rising prices.
Inflation or deflation?
The inflation debate is polarising opinion among economists. One group sees the primary concern to be deflation as unemployment prevents rising prices, but others argue that inflation is caused by an increase in the amount of money in circulation relative to the amount of goods and services being sold.
Given that short-term signals point to a period of deflation, investors could be forgiven for asking why they need to be mindful of higher inflation. It’s simple: even at modest levels, inflation can seriously reduce spending power.
Governments and central banks will look to keep inflation under control. However, as the impact of the pandemic unwinds, they may tolerate inflation levels slightly above the current two per cent target rather than initiating inflation-prevention policies that could see economies retreat.
Assets left as cash with inflation running at two per cent a year for 20 years could result in a 33 per cent loss in “real terms” — at four per cent a year, the real value falls by more than half.
Considerations for investors
Investors looking to preserve wealth may need to take on risk — and be comfortable seeing the value of their money fluctuate. This still leaves them the conundrum of where to invest in an environment that is uncertain and hints at the prospect of higher inflation.
The recent increased demand for inflation hedges, such as precious metals and inflation-protected bonds, suggest that many investors are already investing with higher inflation in mind.
Demand for gold typically increases when “real” inflation-adjusted interest rates and government bond yields are low or negative. This helps explains gold’s strong run since the stimulus packages were announced, but another precious metal that is often overlooked is silver. While gold has recently reached an all-time high, silver is still around half its record high, despite rising sharply during the pandemic.
Meanwhile, equities have long been considered to have inherent inflation-protection characteristics, and several studies back up that assertion. For instance, Credit Suisse’s latest yearbook shows that global equities have outstripped inflation by five per cent a year since 1900.
Yet, there are caveats: not all equities are the same, and depending on the environment, some stocks will fare better than others. And while inflation is not prevalent yet, the stock market would likely price in any impact on companies, long before it became a reality.
The higher inflation debate will continue to simmer. While the latest generation of investors may not experience it at first hand just yet, they should bear it in mind when appraising their portfolios. They may need to step up the risk ladder to achieve their financial goals, aware that simply sitting on cash is risky too — even when inflation remains modest.
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