The inflation rate, or the rate at which prices are increasing, is going up in 2021, with the core US inflation rate up to 5.4% in mid-2021. That’s a fairly big number, given the US inflation rate stood at 1.4% only last January.
That has an impact on both consumers and investors. When inflation rises, consumer prices rise with it. Common goods like lumber, gasoline, semiconductors, and grocery items like bacon and bananas have seen prices soar this year as a result of rising inflation, meaning that consumers’ paychecks might not go as far. If wages are rising at the same time as inflation, the impact on consumers is much less severe.
Rising inflation can also affect the stock market. Traditionally, rising inflation has tempered stock market growth, as consumers have less money to spend and the Federal Reserve may step in to check rising inflation by making loans and credit more expensive with higher interest rates.
What’s an investor do when inflation is on the upswing? Often, it means adjusting investment portfolios to protect assets against rising prices and an uncertain economy.
Inflation Basics, Explained
Inflation is largely defined as a continuing rise in prices. Some inflation is okay – historically, economic booms have come with an inflation rate at about 1.0%-to-2.0%, a range that reflects solid consumer sentiment amidst a growing economy. An inflation rate of 5% or more can be a different story, with higher rate levels associated with an overheated economy.
Inflation rates often correlate to economic growth, which is not always bad for consumers. When economic growth occurs, consumers and businesses have more money and tend to spend it. When cash is flowing through the economy, demand for goods and services grows and that leads food and services producers to raise prices. That triggers a rise in inflation, with the inflation rate growing even more as demand for goods and services outpaces supply.
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Conversely, when demand slides and supply is in abundance, prices fall and the inflation rate tumbles as economic growth wanes. In 2021, however, the US economy is heating up after muted growth in 2020, and the inflation rate is on a significant upward trajectory.
In the United States, the main barometer of inflation is the Consumer Price Index (CPI). The CPI encompasses the retail price of goods and services in common sectors such as housing, healthcare, transportation, food and beverage, and education, among other economic sectors. The Federal Reserve uses a similar index, the Personal Consumption Expenditures Price Index (PCE) in its inflation-related measurements. Economists and investors track inflation on both a monthly and an annual basis.
What Causes Inflation?
Historically there are two types of inflation: cost-push inflation and demand-pull inflation.
This type of inflation is an economic condition when goods and services are limited in supply, and where demand “pushes up” prices on those same goods and services. Take the cost of lumber in the first half of 2021, which was up substantially. Any increased price of lumber for building and construction leads to a lower lumber supply. With demand for lumber both sustained and intense, the price of lumber rises – or is “pushed” higher. Cost-push inflation also often occurs following a natural disaster (i.e., like when a hurricane closes oil refineries, leading to a lower supply of oil and gas, which leads to higher prices for both commodities.)
This type of inflation occurs when prices rise in the consumer economy. When jobs are plentiful and consumer sentiment is high, or the government has pumped a large fiscal stimulus into the economy. People tend to spend more money on goods and services. Yet if the goods consumers are limited (such as smartphones or used cars), competition for those goods rises, and so do the prices for those goods.
Demand-driven inflation is often referred to as “too many dollars chasing too few goods”, meaning the competition among consumers for specific goods and services drives prices significantly higher.
Recommended: A Closer Look at 7 Factors That Cause Inflation
Inflation’s Impact on Stock and Bond Investments
Inflation impacts both stock and bond markets, but in different ways.
Inflation and the Stock Market
Inflation has an indirect impact on stocks, primarily reflecting consumer purchasing power. When inflation rises, that puts pressure on stock market returns to keep up with the inflation rate. Consider a stock portfolio that earns 5% before inflation. Add the 5.4% inflation rate US investors have seen (on average) over the past year, and the portfolio actually loses 0.4% on an inflation-adjusted basis. Plus, as prices rise, retail investors may have less money to put into the stock market, reducing market growth.
Conversely, some inflation stocks can perform well in periods of high inflation. When inflation hits the consumer economy, companies boost the prices of their goods and services to keep profits rolling, as their cost of doing business rises at the same time. Consequently, rising prices contribute to higher revenues, which helps boost the price of a company’s stock price. Investors, after all, want to be in business with companies that have strong revenues.
Overall, however, rising inflation raises the investment risk of an economic slowdown. That scenario doesn’t bode well for strong stock market performance, as uncertainty about the overall economy tends to curb market growth, thus reducing company earnings which leads to sliding equity prices.
Inflation and the Bond Market
Inflation can crimp bond market performance, as well. Most bonds like US Treasury, corporate, or municipal bonds offer a fixed rate of return, paid in the form of interest or coupon payments. As fixed-income securities offer stable, but fixed, investment returns, rising inflation can eat it those returns, further reducing the purchasing power of bond market investors
What to Invest in During Inflation
Investors can take several action steps to protect and potentially outperform with their portfolios during periods of high inflation. You don’t have to worry about choosing the best investments during hyperinflation, because it’s highly unlikely that runaway inflation will occur in the United States.
Choosing inflation investments is like selecting investments at any other time–you’ll need to evaluate the security itself, and how it fits into your overall portfolio strategy both now and in the future.
For instance, investors might consider stocks where the underlying company can boost prices in times of rising inflation. Consider a big box store with a global brand and a massive customer base. In that scenario, the retailer could raise prices and not only cover the cost of rising inflation, but also continue to earn profits in a high inflation period.
Consumer Goods Manufacturers
Think of a consumer goods manufacturer that already has a healthy portion of the toothpaste or shampoo market, and doesn’t need excess capital as it’s already well-invested in its own business. Companies with low capital needs tend to do better in inflationary periods, as they don’t have to invest more cash into the business just to keep up with competitors – they already have a solid market position and already have the means to produce and market their products.
TIPS – Treasury Inflation-Protected Securities
Treasury Inflation-Protected Securities can be a good hedge against inflation. By design, TIPS are like most bonds that pay investors a fixed rate twice annually. They’re also protected against inflation as the principal amount of the securities is adjusted for inflation, based on Consumer Price Index levels.
Precious metals, oil and gas, and orange juice can all be good inflation hedges, as well. Most commodities are tied to the rate of inflation and can capitalize in high inflationary periods. Take the price of gasoline, which rises as inflation heats up. Businesses and consumers are highly reliant on oil and gas, and will likely keep filling up the tank and heating their homes, even if they have to pay higher prices to do so. That makes oil – and other commodities – a good portfolio component when inflation is on the move.
Recommended: A Guide to Investing in Precious Metals
By investing in short-term bonds and bonds funds, you’re not locked into today’s low rates for the long term. When interest rates rise, you can purchase new investments that reflect more favorable rates.
Investors should proceed with caution when inflation rises. While low inflation can indicate a healthy economy, high inflation can be a precursor to a recession. Massive changes to a well-planned portfolio may do more harm than good, and you shouldn’t toss out a long-term investment plan shouldn’t be deep-sixed just because inflation is moving upward.
If you’re ready to build a portfolio, a great place to start is via the SoFi Invest brokerage platform. You can use it to purchase stocks and exchange-traded funds that you either select yourself or let the platform’s algorithm choose on your behalf.
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