The Effect of Worldwide Inflation on Your Investments
Around the globe, the rate of inflation has been increasing at an alarming rate, with the average for 2022 forecast at 8.8%.
In an attempt to combat this and slow down the economy – which is skyrocketing the price of consumer goods – dozens of countries, including the US, UK, India, South Korea and many more, have raised interest rates to increase the price of borrowing.
The cumulative effect of these two events has significant consequences for investors, with asset classes being influenced to differing extents by these economic pressures.
Overall, the stock market falls.
In general, rising interest rates caused by inflation facilitate a drop in stock prices for several reasons.
When interest rates are high, borrowing costs increase, discouraging businesses from fuelling fast growth with loans, resulting in slower business growth. During times of high inflation, consumers also typically buy less since the price of goods is high, which contributes to lower business activity.
As such, the value of company stocks is lower compared to normal economic conditions.
In the short term, investors migrate away from the stock market and choose to put their capital in fixed-income investments, providing a safer alternative to volatile stocks when interest rates are high. They offer a regular income to the investor. This makes stock prices drop even further.
High-growth stocks are hit hard.
High-growth stocks are some of the assets worst hit by raising interest rates.
This is because high-growth companies rely on their ability to borrow money to fuel their rapid growth, which gets significantly more expensive to do when interest rates are raised, forcing these businesses to curb their borrowing and slow their growth.
Noting this, many investors flee from these stocks to those of more stable companies less prominently affected by this economic pressure. Under these circumstances, share prices of high-growth stocks – typically comprising newer, small-medium companies and start-ups – plummet.
Large, stable companies weather the change better.
On the other hand, the price of stocks belonging to larger, more established, slower-growing companies tends to decline less during this time due to these businesses’ healthy cash flow and decreased reliance on borrowing.
Though they still tend to decrease in value due to these harsher economic conditions, established, slower-growing stocks experience a minor hit than their high-growth counterparts.
Fixed-income market increases in popularity.
During periods of high inflation and rising interest rates, many investors opt to pull out of high-growth investments and redirect their capital into value stocks, contributing to the reduced price of growth stocks.
These more stable companies typically have a strong cash flow and pay investors a regular income, making them a more attractive option during economically testing environments.
As such, these investments gain popularity and experience higher comparative performance compared to other investment types in normal market conditions.
Bonds become less valuable.
Bonds are one of the worst-hit asset classes during periods of high inflation, with the price of bonds on the market currently declining.
This is because bonds typically have fixed interest rates, which are devalued in a high-interest rate climate, similarly lessening the bond’s value at maturity.
In addition, new bonds are always issued, and these will have interest rates aligned more closely to those in the current economic climate, making them more attractive to investors.
This contributes starkly to the price decline of bonds currently on the market, as these bonds must adopt a more competitive price to appeal to investors, despite their comparatively low-interest rates.
A mixed effect on commodities.
Current economic conditions – high inflation and high-interest rates – are thought to harm commodities after years of prospering growth in this asset class.
Inflation typically has a positive correlation with the price of commodities. However, this summer, the cost of items such as precious metals, energy, and agricultural products such as corn has declined after years of high growth and high market prices – likely due to hiked interest rates (designed to curb inflation) and other market influences.
The price of commodities is expected to decline further – except for natural gas prices, which are still in huge demand due to the Russian conflict.
Compared to other asset classes, real estate investments tend to weather inflation and rising interests well, with their net income increasing during these economic conditions.
This is because, alongside inflation, property values increase, and rent can be expected to increase, too, generating more income for real estate investors.
This makes real estate investments – whether privately owned holdings or shares in investment vehicles such as REITs – suitable investments to hedge against the detrimental effects of many other investment types in this current economic climate.