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How inflation impacts investments and financial markets

All of the recent challenges over a relatively short period are contributing to the current high inflation environment that is impacting business and individuals on many levels, including financial markets and investments.
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by Tate Mudzi – Consulting Leader: Retirement and Investment Consulting, Mercer Marsh Benefits South Africa , 

10/10/2022 · 4-minute read

The onset of the COVID-19 pandemic and subsequent lockdowns enforced by various countries saw the disruption of global supply chains as factories closed and bottlenecks at maritime ports delayed the supply of goods. The above, coupled with low interest rate stimulus packages issued by governments in a bid to reduce the financial impact of lockdowns, meant that there was too much money in circulation. A big catalyst of inflation.

More recently, the conflict between Russia and Ukraine has curtailed the supply of oil and gas from Russia, due to the sanctions imposed by the West, driving up the price of oil and gas. With both Ukraine and Russia being large grain producers, supply has become limited, leading to increases in food prices. All these challenges over a relatively short period are contributing to the current high inflation environment that is impacting business and individuals on many levels, including financial markets and investments.

What is inflation?

The International Monetary Fund (IMF) defines inflation as the rate of increase in prices over a given period of time. Inflation is typically a broad measure, such as the overall increase in prices or the increase in the cost of living in a country1. There are three main causes of inflation:

  • Demand-pull inflation - demand is higher than the supply of goods in the market
  • Cost-push inflation - high costs of producing goods, resulting in increases of prices of goods sold
  • Built-in inflation - demand of higher wages by workers, leading to businesses increasing prices of goods to offset the demand

The most commonly used denotations of inflation are Consumer Price Index (CPI) and Producer Price Index (PPI).

Is Inflation a bad thing?

Depends on the viewpoint. For starters, too much inflation is not a good thing for an economy. Inflation erodes savings and purchasing power and increases the cost of borrowing for consumers. People tend to spend less in a high inflationary environment.

On the other hand, those with tangible assets such as property tend to gain as inflation sees an increase in the price of their assets. Some speculators may see a high inflationary environment as an opportunity to buy stock in companies with the expectation of better returns based on the profitable nature of that business in a high inflation environment.

How does Inflation impact the financial markets and investments?

Various World Reserve Banks have utilised monetary policy in the form of raising interest rates as a tool to slow down the pace of rising inflation. The South African Reserve Bank has been no different, delivering its biggest increase in borrowing costs in almost two decades and signalling a faster pace of hikes through next year. The repurchase interest rate recently rose to 5.5% from 4.75%2. 

The relationship between inflation and stocks can be very complex. In the short-term, we have witnessed increased volatility in the markets. This is a result of sell-offs as investors react to the uncertainty caused by a high inflationary environment. The negative sentiment comes from the notion that high inflation can lead to a squeeze in corporate profits because of higher input costs. Furthermore and from a valuation standpoint, growth stocks drop in price during high inflation. Value stocks tend to outperform growth and income stocks during periods of higher inflation3. In line with the above-stated monetary policy response, investors tend to substitute stocks for lower priced bonds.

Three key considerations and actions:

  1. While the impact of inflation is clear, as an investor the key is not to panic, especially if your outlook is long-term. Making sudden and rash decisions means that you could lose out financially in the end.
  2. If your investment strategy or portfolio remains appropriate to meet your long-term goals, don’t sell out of riskier assets to safe haven assets during times of heightened volatility. Doing so may destroy value over time.
  3. Speak to an experienced and qualified financial advisor about your retirement and investment goals to make sure your current investments align and will be met.

The anticipation in the end is that inflation will be transitory and will stabilise during the course of 2023. With inflation coming down, this will result in Reserve Banks reducing interest rates and increasing money in the hands of investors. Corporate earnings will improve and bring about positive sentiment in the markets.

1 https://www.imf.org/external/pubs/ft/fandd/basics/30-inflation.htm

2 https://www.bloomberg.com/news/articles/2022-07-21/south-africa-surprises-with-its-biggest-rate-hike-in-two-decades

3 https://www.investopedia.com/articles/investing/052913/inflations-impact-stock-returns.asp#:~:text=Key%20Takeaways,volatile%20when%20inflation%20is%20elevated

Disclosure:

The information in this report is general in nature and is not intended as investment or economic advice, or a recommendation to buy or sell any security or adopt any investment strategy. Additionally, it does not take into account any specific investment objectives, tax and financial condition or particular needs of any specific person.

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