Consumer or producers or policymakers or central banks have one characteristic feature common in them – They are all affected by inflation which is a critical and cyclical macro indicator. With repsect to change in different time periods the capital markets also have to be adjusted to the far reaching implications of inflation. Almost everything is affected by inflation even something as basic as investment returns. Putting forward the theory of real returns which is nominal return less inflation is important for all investors to succeed in real life.
For example, we can look for ourselves how inflation is a silent money killer – for normal savings bank account return of 4% the customer is actually making a loss if we factor in the 12 month inflation value of 6%.
With that understanding now in place, let us look at how inflation impacts multiple asset classes.
Inflation having an inverse relationship with interest rates impacts fixed income investments the most. With each point increase in inflation each investor alson wants to increase their return on investment so that they could beat inflation. Investors will usually shift to high yielding products than current ,ower yielding ones as interest rates on debt instruments are fixed over term. Debt investments dut to their characteristic fixed rates tend to lose the most in a rising inflation environment.In such kind of situations, the central bank usually takes actions around monetary policy and systemic liquidityto manage interest rates or yield or debt products but fundamentals catch up ultimately. In such cases people look for Infaltion Prtected Securities – a bond that adjusts yield to inflation and floating rate bonds.
The case of inflation surrounding equities is a little volatile and could shift depending upon the level of inflation, nature – transient or persistent, the external macro environment, corporate sector exposure, balance sheet structure and pricing power. An inflation rate of around 2-6% is generally considered good for equities while a rate of 10-14% is considered extremely high and bad for equities. Corporates in such cases increase the price of the final product in accordance with the rate of inflation due to the rising prices of raw materials and at last the consumer has to suffer the wrath of inflation while the companies maintains its tradebook. This generally leads to a better revenue for the company and the reults are reflected in the stock price of the company But if the demand is suppressed due to weaker consumer sentiments, high unemployment, sector disruption or any other reason, then corporates would find it difficult to pass on the raw material price rise to final product price hikes. This will again be reflected in the stock prices of the companies.
The real, physical assets that act a hedge against inflation act and their prices define current inflation levels are called commodities. Inflation levels are indicated by their prices. Inflation is a weighted index of prices of different goods and services – raw materials (wholesale inflation) and final products (consumer inflation) – combined in a basket. Different government agencies determine the ratio of theses items in the basket. Naturally, commodities (metals, agricultural produce) tend to do extremely well in a scenario of rising inflation.
The same relationship will hold true for gold as well because at the end of the a commodity after all. For countries like India gold is a preffered choice of investment in times of inflation as it acts as a hedgeGnd hence it is also called a ‘premium store of value’. Unsuprisingly this is not always the case as and when central bank take inflationary measures and raise the interest rates, gold becomes the lesser option for investors. The reason people tend to prefer gold over other assets is due to its various underlying characteristics such as return generating ability over a oeriod of time which has been tried and tested and a significantly low correlation among other asset class in both expansionary and recession periods.Investors also look at gold as an ‘alternative currency’ or ‘currency of last resort’ especially in countries where local currency is is losing value.
Inflation has a direct relation with property prices which tend to increase with rise in inflation rates as landlords and home-owners demand higher rent or home prices to offset high consumption costs. In such cases real state also becomes an asset with positively high correlation with inflation. Investors in such cases invest in exchange traded funds for real estate which give better return in this class rather than owning something physical such as real pieces of land or industrial property.