Far fewer components of macroeconomics affect any country’s economy more than inflation. The rationale behind it is not crazy: if the prices of goods keep rising, people will be paying more money for items a lesser amount would previously buy; once that keeps happening, it squeezes the pockets of the people and the cost of living goes up; and when people have less money to spend (disposable income), it slows economic activity because countries rely on buying and selling activities of its people to collect taxes.
When inflation keeps accelerating, think of it like a growing child—you don’t notice the growth every day, but eventually, you have to buy new clothes because the old ones don’t fit. That’s inflation in action!
Causes of Inflation: Demand-Pull vs Cost-Push
Typically, inflation occurs due to two main factors: demand-pull and cost-push. Demand-pull inflation happens when demand for products outpaces supply, driving prices higher. On the other hand, cost-push inflation occurs when production costs rise, leading to increased prices for consumers.
For investors, inflation has high implications. As it quickens, the value of cash savings can decrease, which means traditional savings will lose purchasing power. The ripple effect is seen with central banks. When inflation spikes, a country’s central bank (think the U.S. Fed) swoops into action and tries to control the situation and improve economic activities again.
The apex bank takes a drastic approach by raising interest rates for other banks. When this happens, it becomes more expensive to borrow money. Therefore, investors—usually high net-worth individuals (HNIs) who borrow money from the banks—will have limited options for investing their money in assets that bring decent value returns.
During “contractionary” policy regimes as we explained, investors try to adopt investment strategies that can outperform inflation—think of real estate, stocks, and commodities as potential inflation-resistant assets.
But do these even work?
We will answer in this article.
How Inflation Affects Different Investment Assets
One way to approach investing during inflationary times is by understanding how different types of assets respond to rising prices. We’ve analysed some assets held up during contractionary economies with a cap on which ones are good or bad investments in times like this.
Stocks
Stocks, which are shares of publicly listed companies that you buy, can provide a hedge against inflation. Many companies raise their prices during inflationary times, which can boost revenue and profits. For example, companies in sectors like energy, consumer goods, and technology often pass increased costs to customers to maintain their profit margins.
However, not all stocks perform equally well during inflation and even after the companies hike their own prices. Oftentimes, the advantage is with brands that sell everyday goods. High-growth technology stocks, for example, may suffer as investors shift toward these stable, income-generating stocks.
In inflationary periods, investors tend to prefer “value stocks”—those from stable, well-established companies. Holding stocks in cost-efficient companies during these periods is usually the right way to go.
Verdict for Stocks: Good.
ETFs
Inflation’s effect on ETFs depends largely on the type of assets they hold. For example, equity-focused ETFs might provide some protection against inflation, as companies often raise prices to keep up with rising costs. On the other hand, ETFs can struggle during inflationary periods because bond yields may not keep up with the rising cost of living. This can erode the real value returns for bond investors within ETFs. Moreover, it is also a viable option during inflation. Particularly those with holdings in sectors that tend to outperform in such times, like commodities, energy, or certain consumer goods.
Verdict for Stocks: Fair.
Treasury Bills
They are short-term government-backed securities, typically maturing in one year or less. Also, they are known to be low-risk and are often considered a safe haven in volatile markets, as they guarantee a fixed return upon maturity.
Verdict for Stocks: Good. Especially for conservative investors prioritising capital preservation.
Commercial Papers
Commercial Papers are short-term debt instruments issued by corporations to cover operating expenses. They are generally unsecured and are issued with maturities of less than a year, often at a higher yield than government securities due to the increased risk.
Verdict for Stocks: Fair.
Bonds
Bonds are generally more sensitive to inflation. When inflation rises, bond yields (the interest paid on bonds) often increase. However, the value of existing bonds usually drops because their fixed interest rates may not keep up with inflation. For example, a bond paying 3% interest may lose value if inflation hits 5%, as it no longer provides an attractive return.
Investors can consider Treasury Inflation-Protected Securities (TIPS), which are bonds indexed to inflation. As inflation rises, the value of TIPS increases, offering a measure of protection.
Verdict for High-Yield Bonds: Good.
Real Estate
Real estate is also considered a strong investment during inflation. Property values and rental income tend to rise along with inflation, which helps real estate owners maintain their buying power. When home prices increase, rental properties can yield higher returns as rents adjust to match new costs.
Commercial real estate investments can also be beneficial, especially in sectors like warehouses, residential buildings, and office spaces in high-demand areas. However, it’s essential to account for maintenance costs, as inflation can also increase expenses for property upkeep.
Verdict for Real Estate and REITs: Good.
Commodities
Commodities, such as gold, silver, and oil, are traditional inflation hedges. When inflation rises, the value of these resources often goes up. They become more expensive to extract, refine, or transport. Precious metals like gold and silver are seen as safe assets, providing a store of value when paper money loses its purchasing power.
Investing in commodities can be done directly, through commodity-specific stocks, or by purchasing exchange-traded funds (ETFs) that track these materials’ prices.
Verdict for Commodities: Fair.
Cash and Savings Accounts
Cash and basic savings accounts tend to lose value quickly during inflationary times. With low interest rates on savings accounts, inflation can exceed the returns, eroding the value of money left in these accounts. For example, if you earn 1% interest in your savings account but inflation is 3%, your purchasing power decreases by 2%.
Verdict for Cash Savings: Bad.
Strategies for Adjusting Your Investment Plans to Hedge Against Inflation
Now that we understand how inflation affects each investment type, let’s explore some strategies for mitigating its impact.
1. Diversify Your Portfolio
Diversification is an essential principle for investors, especially during inflation. Holding a mix of assets—including stocks, bonds, real estate, and commodities—helps balance risks. By spreading investments across various asset classes, you can reduce the risk of significant losses if one asset class underperforms due to inflation.
2. Invest in Inflation-Protected Securities
As mentioned, TIPS can be a valuable addition to an inflation-resistant portfolio. These securities increase in value as inflation rises, making them particularly useful for conservative investors looking to protect against inflation.
3. Focus on Dividend-Paying Stocks
Stocks that pay dividends provide regular income, which can help offset the effects of inflation. Dividend-paying stocks tend to belong to established companies with reliable cash flow. Over time, these stocks can offer a steady source of income that keeps pace with rising costs, making them a practical choice for income-focused investors.
4. Consider Real Assets
Real assets, such as real estate and commodities, often retain or increase in value during inflationary periods. By including real estate or commodity ETFs in your portfolio, you add investments that historically perform well as inflation quickens. Even a small allocation to real assets can provide stability and hedge against the declining purchasing power of cash.
Long-Term vs. Short-Term Inflation Strategies
The impact of inflation varies depending on an investor’s time horizon. For long-term investors, focusing on assets like stocks and real estate can provide a reliable hedge against inflation over decades. These investments often yield better returns than cash or bonds in the long run.
For short-term investors, it may be wiser to lean toward assets that offer immediate protection, such as TIPS or commodity Exchange-Traded Funds (ETFs). High-yield savings accounts, while modest in returns, can still offer a safer place to store cash in the short term.
What Else to Consider in Your Investment Strategy During Inflation
Aside from choosing assets, it’s essential to consider factors like fees, tax implications, and interest rates.
Monitor Fees
High fees can diminish returns, especially in low-yielding investments. During inflation, maintaining cost-effective investments becomes even more crucial. Choosing low-fee index funds or ETFs can help maximise returns while reducing unnecessary expenses.
Be Aware of Taxes
Inflation can affect your tax liabilities, particularly with capital gains. When assets like stocks or real estate appreciate, capital gains taxes apply on the profit made from selling them. In inflationary periods, these gains may not reflect actual increases in value after adjusting for inflation, so understanding tax implications is key to effective portfolio management.
Keep an Eye on Interest Rates
Inflation often leads to higher interest rates as central banks aim to stabilise the economy. This can impact the cost of loans, mortgage rates, and even the returns on certain investments. Staying informed about interest rate trends is essential, as they can affect which assets perform well and which will likely struggle.
Wrapping Up
Investing during inflation calls for flexibility and strategy adjustments. The strongest defense is a well-diversified portfolio that aligns with your goals and risk tolerance. You can focus on assets like dividend stocks, real estate, and commodities—historically resilient during inflation—to help preserve your wealth.
As an active investor, it is also important to keep an eye on economic trends and adapt as inflation shifts. This lets you know the season to buy more assets (depending on the economy state), hold, or sell them as the market makes its runs.
The way to stay winning when investing in an inflationary market is to counter its impact and secure long-term financial stability through assets that provide decent to high-value returns to beat inflation.
