Recent economic talk has been centred on two words that has the same first two letters: inflation and interest. These two phrases have a not-so-favourable connotation to a third word with the same said first two letters that you and me are familiar with: investing.
What About Inflation And Interest?
Inflation, as we know it, is the increase in prices and decline of the value of money. Grown at a steady pace, inflation is healthy as it is associated with economic growth. Too much inflation over a given time, however, leads to hyperinflation and this causes prices to rise unchecked and hastened the decline of monetary value.
Interest rates are one of the main tools used by governments and central banks to control the rate of inflation. A rise in interest rates will incentivize people to keep more cash as opposed to spending it since there is an associated yield. Also, it would raise the cost of borrowing and thus, provide a check on growth which is a basis for inflation.
Both are part and parcel of the whole scheme of things, and both can generally move and/or affect the economy and market. Notwithstanding other factors and issues, balancing between inflation and interest rates is a delicate act.
What Is Happening Now?
The current narrative of the situation is that inflation was the result of supply chain issues caused by the COVID-19 pandemic. Pent-up demand and a dearth of supply of goods and services brought about the rise of prices across, and these caused a chain effect across the entire economy.
The Federal Reserve, the central bank of the United States, had announced plans of tapering, i.e., reduction of monetary stimulus of the economy, one of the factors in contributing to inflation. With tapering, interest rate hikes are expected soon by market participants, and when the Federal Reserve starts to increase interest rates, a large portion of the world’s economy would be affected, one way or another.
Effects On Investment
The problem about these two is that too much of one thing is generally not so good for investors. Too much inflation, and you will get loss of value of your cash, and bond payouts may also devalue since they pay a fixed amount.
Too high an interest rate, your equities and REITs are affected since it raises the cost of borrowing and dampens leveraged growth; bonds are affected as their annual coupon rate may go lower than the interest rate itself and thus become unpopular; commodities are affected as holding them do not provide yield.
So how do we protect our investments? Simple. The above paragraphs talked about which asset classes are negatively affected by high (not hyper) inflation and rising interest rates. If we put a contextual mirror to them, you can flip them to see the positive side of things.
Still don’t get it? Here it goes. Inflation is good for equities, REITs and commodities, while a high interest rate allows cash to provide yield, generally speaking. In essence, the underlying message that I want to convey is: stay diversified. Diversification is key in protecting your investment portfolio in all kinds of economic weather.
One More Thing About Bonds
If you had noticed, bonds were unfavourable in times of high inflation and high interest rates, so I guess the next question would be: do we still need bonds in our investment portfolio?
My answer (and I am breaking my usual “it depends” rule) is yes. The inflation-interest rate scale is but one of the spectrums that is commonly used and observed in economic situations and market conditions. Bonds are useful in the recession part of the expansionary-recessionary scale in which it is a typical go-to asset class, and it is favoured during deflation in the inflation-deflation scale. Putting it simply, the whole thing is like a multi-faceted radar chart with different axes representing the range of factors.
Stay safe, stay calm, stay invested.