We constantly read news reports of how increasing inflation can impact our monthly budgets, make fuel more expensive, and increase the prices of daily use goods. But have you ever thought about the inflation effect on asset classes?
In this blog, we will explore the effect of inflation on different assets and tell you ways that can help you protect your assets from the perils of hyperinflation.
What is inflation?
Inflation can be simply understood as a progressive increase in the prices of commonly used goods and services. The price increases happen over a prolonged time and are marked by the overall decrease in the purchasing power of your money.
For example, let’s assume that 1 kg of apples cost Rs 300 today. The next year, it costs Rs 320 per kg due to inflation. This means that you will have to spend Rs 20 more to buy the same goods the new year than you did last year. Thus, the value of your money decreased significantly as inflation increased.
The most significant factors that affect inflation in an economy are:
- An imbalance in the demand-supply equilibrium
- Excess supply of money in the economy
- Cost-push effect
However, inflation is not a big, giant evil. A controlled, stable, and predictable degree of inflation is necessary for a healthy economy. It helps the currency retain its rightful value and keeps people’s expenditure in check. Moreover, low inflation rates encourage a country’s citizens to save money and invest it, making them contribute to the economy’s growth.
That being said, high inflation rates can not only eat into your savings but also have an impact on your assets. Let’s understand this in-depth.
How does inflation affect different asset classes?
1. Stocks and mutual funds
Equity is one of the investors’ most sought-after asset classes, which promises to deliver huge returns over time. Stocks have proved to outperform inflation consistently over the years.
However, it is essential to note that larger companies are more likely to be impacted by inflation, followed by mid-sized and smaller companies. While smaller degrees of inflation may be beneficial for companies listed on the stock exchange, hyperinflation can be damning.
Theoretically, a company’s revenues are likely to increase with increasing inflation. For example, if inflation leads to higher input costs for companies, they pass on the same to their customers by raising the prices of the goods and services they offer, in tandem with inflation. This can lead to a higher EPS, increasing the stock price, getting the investors a handsome return.
It must also be noted that if the prices of the goods and services offered by a listed company shoot up, hand-in-hand with inflation, it can create a demand deficit that can hurt the company’s sales and revenues. This can bring the stock price down, ultimately making the investor lose their money.
2. Fixed income instruments
Fixed income securities like Government bonds and corporate bonds, T-bills, etc., have an inversely proportional relationship with interest rates. This means that when interest rates in the country decrease, the yield of fixed income securities will increase. Similarly, when the interest rates rise, the yield can reduce.
With the increase in inflation, the interest rates in the country generally follow an upward trajectory. This means that the investment in fixed income will not generate as much returns as it promised. Conversely, when inflation eases, and the interest rates come down, the yield of fixed income instruments rises.
3. Savings in different types of bank accounts
A savings bank account promises you a fixed percentage of return on the money you keep in your bank account. This interest is determined by several factors and differs for each bank. Ideally, savings accounts in India offer an average interest rate of 2.70% and 5.25% p.a.
It can be understood that the meagre interest rate on a savings account cannot cover the costs of items that would become expensive due to inflation. Therefore, the interest on the savings account will be insufficient and will fall short of competing with inflation. Let’s compare this with the current consumer inflation rate in India, which is around 5.56%. The amount you put in a savings account will give you a return at a rate lower than the inflation rate. This is not of much benefit as your money still loses value.
An alternative to this is to put your money in a Fixed Deposit account. In a fixed deposit, the amount you put in gets locked for a predetermined period and you may withdraw the principal on maturity. The interest rate for a fixed deposit is determined at the beginning of the term and does not fluctuate, ensuring you return at a given constant rate. The interest rate differs from bank to bank and generally ranges between 5% to 7%. At present, HDFC Bank provides among the highest interest on FDs, which ranges from 6.20%-6.65% for a maturity period between 33 months and 99 months. Even though it is a better option than a simple savings account, it only beats inflation by a narrow margin. It is thus important to choose where you invest, and keeping FDs as a back up option (or when you have a low risk appetite) can be the way to go.
4. Real estate
With rising inflation, the cost of renting, subletting, and buying homes increases. In case of high inflation, the banks may hike their interest rates, and you might have to pay an EMIs of a higher amount for the loan you might have taken to purchase the property. High inflation can also lead to a bullish real estate market wherein you might get a little less than what your property is worth if you decide to sell it.
If you are a landlord, you can charge your tenants a higher rent because of higher inflation, which increases your return.
As for investments in REITs and real estate ETFs, these have historically beaten inflation benchmarks and have delivered long term returns of over 10%. Therefore, investing in REITs or real estate ETFs might be better than physically buying a piece of property whose value can diminish in hyperinflation environments.
5. Commodities
The commodities market and inflation have a directly proportional relationship where the prices of commodities go up as soon as the inflation increases. This allows the investor to get higher returns if they have invested in the commodities segment. Thus, commodities as an asset class can act as a natural hedge against inflation to protect your investment and increase its value if inflation rises.
6. Gold
Gold is also a commodity, albeit one of the most precious ones. Since it is also a safe haven asset, its prices begin an upward spiral in any crisis like hyperinflation, war, and other economic crises. The prices of gold are also highly sensitive to inflation and shoot up at any sign of upward movement in the inflation rate.
So, in times of hyperinflation, gold prices will increase even when all other asset classes might be in the red, making it a great investable asset, apt for portfolio diversification. One of the best ways to do so is to buy sovereign gold bonds backed by a Government guarantee and give you stable returns, even during hyperinflation.
Learn more about the risk and returns involved with fixed income investment strategies.
How can I protect my assets from the effects of inflation?
1. Stay invested for the long term
This is the most important- do not get bogged down by corrections in the market due to inflation. Look at the bigger picture and stay invested for the long term to fulfil long term goals related to retirement, paying off loans, children’s education, marriage, etc.
2. Diversify your portfolio
In a hyperinflationary environment, the best thing you can do is diversify your portfolio to give it an edge. Apart from the good old stocks and mutual funds, including REITS, sovereign gold bonds, and other alternative investment classes, have historically performed well under hyperinflation pressure. However, it is recommended to consult a SEBI-certified investment advisor before making such decisions. TejiMandi offers portfolio management services and advice to help you make the most out of your investment, even during hyperinflation.
3. Don’t stop your investment
Many investors stop their SIPs and stop investing altogether when there is an increase in inflation. On the contrary, it is beneficial to continue investments. Rather, it is recommended that one use the dip in the market to leverage and increase their investment.
4. Invest in equities and mutual funds
Stocks and mutual funds have stood the test of time when generating high returns for their investors, helping them beat inflation. Over the last 10 years, Nifty has seen a growth of over 226%, while Sensex has witnessed a growth of over 231%. Thus, equity and mutual fund investments help you increase your wealth significantly; they also give you a hedge against inflation.
You must do your research before investing in equities. Read all about it in our article on equity investments: benefits, considerations, and must-know tips on the TejiMandi blog.
5. Opt for inflation-indexed bonds
These are a type of bonds that have been designed to beat inflation via protecting both the principal amount and the interest.
6. Look towards the commodities segment
Diversifying your portfolio and including commodities can also give you an edge against inflation. If there is an increase in inflation, the value of your investment will also increase.
The takeaway
Inflation is not all harmful for a country’s economy; controlled inflation is key to maintaining an equilibrium between demand, supply, and cash flow into the economy. However, hyperinflation can eat into your investments and reduce their value. Thus, it is important to understand the methods you can use to protect your assets from eroding.