The investment community is divided on whether inflation is more than just transitory. According to its latest World Economic Outlook Update, the International Monetary Fund expects inflation to return to its pre-pandemic ranges in most countries in 2022, but uncertainty remains high. How can investors mitigate inflation risks, and what is the role of wealth managers in such an environment?
What is Inflation?
In simple terms, inflation is the rise in the price of goods and services based on supply-and-demand dynamics that could affect specific goods and services or a broad range thereof. Demand-pull inflation is caused by a surge in demand for a broad range of goods or services and is often associated with economic expansion or expansionary fiscal policy that boosts employment and wages across the economy. During such times, credit tends to be easier to obtain which avails more funds to consumers, further boosting demand. Also, consumers wary of rising prices may rush to buy products before prices rise further.
Cost-push inflation occurs when production costs rise due to higher prices of raw materials and wages. Demand for goods is unchanged while the supply drops due to higher production costs. The added costs are passed onto consumers in the form of higher prices of finished goods.
Inflation is not bad news for everyone. For example, the debt service capacity improves for borrowers with fixed-rate debt and growing revenues due to inflation, while the relative return for fixed-rate lenders diminishes. Meanwhile, profitability declines for floating-rate borrowers who cannot pass the higher debt service cost onto their customers.
Relationship between Inflation, Interest Rates and Exchange Rates
Central banks use interest rates to manage inflation. They increase interest rates when inflation is high and reduce them when inflation is low. This, in turn, affects currency exchange rates. Currencies with high interest rates tend to weaken against those with lower interest rates, making imports more expensive and exports cheaper. A weaker exchange rate makes the price of exports more competitive in international trade and attracts foreign investment. This mechanism automatically defends weaker currencies, allowing them to recover over time.
Hedging against Inflation
Investors can plan for inflation by investing in asset classes that outperform the market in an inflationary environment. For example, the cash flow from investments in infrastructure and real estate tends to rise with inflation and so does their value. Capital-light businesses, such as technology, media and telecommunication services, whose revenues rise with inflation are also winners in an inflationary environment. Similarly, investments in floating-rate debt feature greater protection as their returns are indexed to inflation.
The Role of Wealth Managers in an Inflationary Environment
Historically, commodities (e.g., gold) and other real assets (real estate and infrastructure) were considered good hedges against inflation. Moderate inflation also tends to benefit stocks. Equity real estate investment trusts (REITs), for example, outperformed the broad market 67% of the time with an average inflation-adjusted return of 4.7%.
Such strategies worked under the prevailing conditions at the time but may no longer be suitable in the current environment. The right wealth manager can help you design an investment strategy within your appetite that protects your wealth against inflation and produces above-average returns.
Contact The Family Office to learn more about inflation-proof investment solutions that protect and grow your wealth.