Investing, particular in the stock market is a risky activity that is driven by external forces beyond the control of individual investors. One of these forces includes inflation which impacts both the economy and investment markets. This article will provide a crash course to explain how inflation may be impacting your current investment strategy.
What is inflation?
Inflation can be described as the sustained rise in the price of goods and services in an economy. It is measured as the rate of change of those prices in which prices typically rise over time but can also fall, which is called deflation. Two of the most popular indicators to measure inflation include:
- The consumer price index (CPI)
- The producer price index (PPI)
The CPI measures the percentage change in the price of a basket of goods and services consumed by households. In Australia, the Australian Bureau of Statistics (ABS) is responsible for calculating and publishing the CPI, which occurs once a quarter. The ABS collects prices across thousands of items which are categorised into expenditure classes. The price changes for each item are calculated and then aggregated to work out the inflation rate for the entire CPI basket. Some of these categories include housing, recreation and culture, transport, health, education, communication, food and non-alcoholic beverages and clothing and footwear. This means that if there has been a 2.5% increase in the price of goods and services over one year, we say that consumer inflation is running at 2.5%.
The PPI measures the price of a basket of goods and services typically purchased by producers and therefore is reflective of the cost pressures faced by businesses.
Does inflation matter?
Inflation is an important indicator for several reasons. The first consideration is that rising inflation can impact economic growth as it results in business and consumer uncertainty. This often occurs where prices for consumer goods rise, but incomes have not been updated to reflect this, which therefore negatively impacts households and their living standards. This also creates uncertainty for businesses around whether these increasing cost pressures can be passed onto other parties such as consumers. Increasing prices can also often result in decreased consumer spending and a reduction in business investment.
How this works in practice is that an increase in commodity prices means that manufacturers have to pay more for the materials they require to produce their goods. This increase either has to be passed onto consumers through an increase in the purchase price or businesses have to manage smaller profit margins.
This similarly impacts consumers and households, as a rise in prices means that consumers have to pay more to receive the same amount of goods or levels of service. Therefore, unless wages rise in line with these increases, consumers may experience a reduction in their living standards or quality of life.
Inflation and interest rates
A rise in inflation can also place upward pressure on interest rates, as lending facilities usually seek additional compensation to provide money that can buy fewer goods and services when it is paid back in the future. This is reflected through the higher interest rates charged to customers which then places downward pressure on the value of some investments, even those seen as long-term investments such as property.
Continued inflation can also have a far-reaching impact on the economy as central banks introduce stricter credit and lending conditions which slows economic growth overall. However, a low and stable level of inflation is regarded as a good thing for economies, with the RBA Governor and Treasurer agreeing that the appropriate target for monetary policy in Australia is to achieve an inflation rate of 2–3%, on average, over time. This suggests that inflation is all about balance, some is okay and can be considered necessary for the growth of economies, however, exponential growth can be damaging.
Does inflation impact investors?
As aforementioned, rapid increases in inflation can make obtaining debt a more difficult process and therefore may reduce the ability of individuals to obtain the finance required to fund their investments.
Inflation also impacts investors and the actual rate of return they receive on their investments. For example, if you invest in a term deposit that pays 4% p.a., and the inflation rate is 2% p.a., your actual rate of return is 2% p.a. Therefore, a higher rate of inflation means investors need a higher rate of return to break even and have a profitable investment.
However, it must be noted that modestly rising inflation is seen as a positive force in the share market as it is consistent with sustainable economic growth. Despite this, inflation above a certain level or unexpected increases can have negative implications for investors which typically result in:
- Increased borrowing costs
- Higher costs of materials and labour
- Reduced expectations of earnings growth
All of which places downward pressure on stock prices, hence hindering the potential returns of investors.
It should also be noted that not all stocks are impacted in the same way and inflation generally affects growth stocks more than defensive assets, but in saying this, fixed interest investors are not immune to inflation changes.
Before investing it is important to consider the impacts of inflation on the value of your assets over time and how inflation may impact your ability to fund particular investments. If you would like some guidance on structuring your current investments to consider the impacts of inflation, please click here to organise a 20-minute complimentary phone call with an EPG Wealth adviser.