With domestic inflation reaching a 40-year high of 7.9% in February, many investors may be wondering how inflation impacts their investments. In this blog, we will cover what inflation is, the most popular measures of inflation, and how inflation could impact investments.
What is Inflation?
Simply put, inflation is a decrease in purchasing power of a given currency over a period of time. As the value of the currency decreases, prices rise, and consumers typically choose to purchase fewer goods and services. The impacts of inflation can be felt at the gas pump, grocery stores, healthcare, entertainment, and other purchases made using the currency affected by inflation.
The US Bureau of Labor Statistics reports the inflation rate by taking the average weighted cost of a basket of consumer goods and services in a given month and dividing it by the average weighted cost of the same basket from the previous month.
To learn more about how the Bureau calculates the Consumer Price Index, they have a Frequently Asked Questions guide publicly available.
The US inflation rate has been climbing since mid 2020, and the US Federal Reserve has signaled that it will take steps to help mitigate rising inflation. In March of this year, the Fed approved its first interest rate increase since 2018 and anticipates six additional increases in 2022 and three in 2023. So how is inflation measured?
Measures of Inflation
The most popular measure of inflation is the Consumer Price Index (CPI). This index measures the percentage change in the price of a basket of goods and services consumed by an urban household. Expressed as an equation, the CPI is equal to the difference in price of household goods and services from year 2 to year 1 divided by the price of household goods in year 1. Once multiplied by 100 to express as a percentage, that equation will provide the Consumer Price Index, as seen in the image below.
To put some concrete numbers to the equation, imagine the cost of books is $20 in 2021 and increases to $21 in 2022. 2022 is Year 2 and 2021 is Year 1. The 2021 price subtracted from the 2022 price is equal to 1, 1 divided by the 2021 price of 20 is equal to 0.05, and 0.05 multiplied by 100 is equal to 5, showing that the price of books increased 5% from 2021 to 2022, as seen in the image below.
Other measures of inflation include the Personal Consumption Expenditures Price Index (CPE) and Gross Domestic Product (GDP). In the United States, the PCE is produced by the Bureau of Economic Analysis (BEA) with data sourced from the Bureau of Labor Statistics (BLS). Gross Domestic Product (GDP) is also measured by the BEA with data collected from government agencies and some private data collectors. To read more about measures of inflation and how the data is collected, visit Brookings for more information on CPI and CPE, and Bureau of Economic Analysis for more information on GDP.
Inflation and Investments
Rising inflation in household goods may mean that investors have less capital to allocate towards investments, potentially deterring new investment activity. But how does inflation affect investments already made? In the case of fixed income securities, like bonds, treasuries, and CDs, rising prices decrease the purchasing power of the fixed income (cash flow) potentially generated by these assets.
With respect to the stock market, in theory, a company’s revenue and earnings should increase as inflation increases, ideally increasing the value of the stock in the face of inflation. However, the amount of inflation should also be considered. A November 2021 John Hancock article noted that various Russell Indices representing specific market cap segments tended to perform better when inflation was roughly 1% – 4%, as illustrated below.
Rolling 12-month average total return (%) across headline CPI levels
Further, various equity sectors have responded differently in previous high and rising inflationary periods. Hartford Funds recently presented historical data in the graph shown below.
Real assets, such as real estate and commodities, have historically had a positive correlation with inflation. U.S. Bank Asset Management Group published an analysis on April 1st of this year that found that real estate classes tend to benefit from higher inflation environments. Real Estate Investment Trusts (REITs) had differing results between Mortgage REITs and Equity REITs in Hartford’s US Equity Sector Performance graph. Historically, Equity REITs have historically had a higher probability of beating inflation, whereas Mortgage REITs did not as coupon payments lose purchasing power in inflationary periods.
In the private markets, it is accepted that inflation typically leads to different purchasing decisions which can potentially deter new investments during periods of high inflation. As inflation increases, the cost of borrowing money can also increase. Valuations tend to decrease, paralleled to what is seen in the stock market in the face of increasing inflation, and asset selection can be impacted as well. Roughly paralleling the average inflationary response in the public equity markets, low to moderate inflation levels of about 2-6% are considered healthy in the case of equity, while inflation up to 10-14% are expected to have a negative impact on private equity investments.
Regardless of asset class, it’s important to note that past performance cannot predict future results, and no asset class should be considered “inflation-proof”.
Putting it All Together
The impacts of inflation can be felt at the grocery store, restaurants, and even in investments across all asset classes. It is important to be aware of the impacts of inflation, and how inflation can impact your return on investment, if realized. In addition, new risks have emerged over the past couple of years that have the potential to negatively affect investments, including the COVID-19 pandemic and the Ukrainian-Russian war, as described in McKinsey’s Private Markets Annual Review, published in March 2022. One tool that may help mitigate the negative impact of rising inflation is portfolio diversification. To learn more about portfolio diversification, check out our recent blog Portfolio Diversification 101.
The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.