It is likely that you have heard a lot of talk about inflation since the beginning of 2022. After many years at record lows, investors, businesses, and families are bracing for a steep rise in inflation this year fuelled by many economic and market forces. If you would like to know more about how to invest when inflation is rising and how to hedge against it, continue reading the article below.
What is inflation?
Inflation refers to the ‘decline of purchasing power of a given currency over time.’ This is measured through the increase in the prices of the goods and services that households buy. The most commonly used indicator of this is the Consumer Price Index (CPI) which is a measure of the percentage change in the price of a basket of goods and services consumed by households in an economy over a period of time. This can also occur in the reverse which is called deflation. This is when the purchasing power of a currency increases, and prices decline.
What causes inflation?
There is no one cause of inflation, but many market forces that result in a rise in prices. In Australia, official inflation as of March 2022 was at 3.5% which has been felt by consumers across the nation as the price of everyday items rise, especially petrol.
One driving factor of inflation is that prices are expected to rise when an economy strengthens. The economy has rebounded well following two-years of the COVID-19 pandemic and the various lockdowns that ensued both in Australia and across the world. Markets have performed particularly well with the ASX ending the 20/21 Financial Year up 24% which was its best performance on record since its inception in 1987. This, in conjunction with government stimulus packages and increased consumer spending following pandemic restrictions has also led to a stronger economy.
Unemployment has also fallen which can be attributed to the high availability of workers due to border closures which have only recently been relaxed. The unemployment rate has fallen to 4.0% as of February 2022 which is the lowest it has been since August 2008.
This is being driven by the ‘talent war’ occurring in many white-collar sectors including tech, law and finance, whereby organisations are experiencing difficulty acquiring and retaining the staff they need. Firms are then forced to increase wages, bonuses, and monetary benefits which arms consumers with more money to spend on goods and services in the economy.
Increased demand means an increase in price. This occurs through companies increasing the price of the goods and services they offer in order to pay higher wages or other primary inputs such as materials. Fluctuations in the Australian dollar can also have an impact on inflation as a lower exchange rate causes imported items to be more expensive and therefore retailers that source foreign goods have to raise prices to cover these costs. Government policies including taxes and subsidies also have an effect on inflation, where an increase in the tax on consumer goods such as tobacco products causes a steep rise in price.
Why is inflation rising now?
The composite effect of the above factors has led to an increase in the cost of living for many Australians as these underlying factors have been simmering beneath the surface, consumers are now feeling the pinch. The Reserve Bank is expected to make an announcement by June alerting consumers about a rise in interest rates which will be for the first time in 11 years. This will have an impact on financial markets, with the industry anticipating a cash rate of up to 2.5%.
Is inflation bad?
The general consensus is that a low level of stable, positive inflation is the best outcome for the economy. However, a steep rise in inflation can be highly damaging as it significantly undermines the buying ability of consumers.
What can I do?
There are a range of ways that investors can hedge against rising inflation to help reduce their loss of purchasing power.
Although keeping some of your assets in cash may seem counterintuitive, keeping a small cash reserve could help you in the long-term. If a sharp rise in inflation causes markets to drop, taking some of the profits off your portfolio and retaining it in cash will provide you with the ammunition you need to make the most of this market fall. However, this is only advantageous if inflation gets out of hand as holding too much cash won’t get you far with an almost zero rate of return and rising costs of everyday items.
For investors who wish to invest their cash it is important to know which sectors will give you the most bang for your buck. Hard commodities including iron ore, copper or other areas of mining may be a beneficial sector for investors as these companies have the ability of passing on the increasing costs of materials and other inputs to consumers. The benefit for investors is that these increasing costs do not eat up the company’s profits and therefore may led to better returns over the long-run.
Another sector which may spike investor’s interest is corn and other soft commodities. Some food producing growth stocks have increased by 50%, reflecting increased demand as more people are eating at home during the pandemic. This, as well as supply chain bottlenecks and poor climatic conditions in other countries has led to more demand for local producers.
Inflation is also likely to have a positive impact on infrastructure both through valuation and earnings. This is due to current economic conditions creating more potential for emerging infrastructure projects such as transport. This may also provide investors with a good portfolio hedge as the increasing costs are passed through to customers by toll roads for example.
Overall, when investors are trying to reduce the negative impacts of increasing inflation it is important to be informed and weigh up the various characteristics of different sectors and how they impact consumers and investors differently. The right investment will be different for each individual and therefore it is critical that investors do their due diligence and are fully informed of the risks, costs and benefits of their choices.
If you are feeling the pinch and would like tailored advice to structure your finances in a way to help you grow your wealth over the long-term, please click the link to organise a complimentary 20-minute consultation with an EPG Wealth adviser.
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