How inflation affects your investments
Higher inflation might make you reconsider some investment decisions.
CIBC Investor’s Edge
May. 16, 2024
9-minute read
After COVID lockdowns ended, consumer demand rushed back for many of the things we went without during the pandemic. At the same time, some supply disruptions continued and store shelves were still bare for some items. This kind of strong demand that outstrips supply is a classic setup that can produce a general rise in prices known as inflation. Because it can have such widespread effects, it’s been much harder to make certain investment decisions without considering its impact.
How inflation affects interest rates
If inflation becomes too volatile, Central Banks are unlikely to let the situation persist. When inflation is too strong or rising too quickly, they’ll often step in to cool it down by raising interest rates. This has been happening in Canada, the U.S. and Europe. Higher rates are likely to put the brakes on inflation at some point, but they also tend to slow the economy.
Overall, inflation indicators are guiding Central Bank decisions and the current path of interest rates. This in turn influences rates on savings accounts and GICs (Guaranteed Investment Certificates) and the terms you’ll be offered when applying for or renewing a mortgage. Inflation is also front and centre when we check out at the grocery store and it’s shaping our “reasonable expectations” for rental increases and salary raises.
How inflation may affect your investment planning
- It can be harder to allocate dollars to investing when inflation increases the cost of living and reduces disposable income.
- You may want to review your investment portfolio mix, because the performance outlook for various assets or asset classes can differ during higher versus lower inflation periods.
- Higher inflation can affect your retirement calculations, and you may want to check the assumptions you’ve used for your inputs.
Stay focused on investing
You’ve heard the saying about money management — pay yourself first. But these days, which self should you be paying first? The one who wants to take the family out for a movie once a week or the one who wants to retire at 50? It’s important to balance short- and long-term goals — we all want to enjoy life now and have the discipline to save for later. But with higher inflation, satisfying both goals is a bigger challenge. When an IMAX movie and popcorn for a family of 4 costs $100 or more and even a fast-food meal can easily set you back $15, we might get the urge to cut back on other not-so-immediate goals.
This makes it even more important to consciously choose to keep saving and, depending on circumstances, you’ll probably want to consider dedicating some portion of that to investing. This conscious decision when other expenses are increasing can make sure that your investments continue to grow. Techniques that automate investing, such as a Regular Investment Plan that routinely moves money into your investment account, can help keep you focused. Another bright spot: higher inflation has meant higher short-term interest rates, which translates into more interest on high interest savings accounts (HISAs) and money market investments. That interest can accumulate and become dollars you could consider putting toward longer-term investment goals.
Revisit the outlook for various investments
Because inflation can affect different asset classes differently, let’s consider some of the historical reactions of stocks and fixed income when inflation moved higher.
Stocks
The relationship between stocks and higher inflation isn’t straightforward, as CIBC Asset Management Senior Portfolio Manager Craig Jerusalim explains:
“Typically, businesses that can raise prices to match inflation and not suffer a loss of revenue are in a good position in inflationary times — consumer staples stocks and companies that offer essential services, for example, are likely to be included in this category. Some financial companies, depending on their lines of business, will benefit from higher interest rates. Real estate-related stocks, utilities and commodity stocks are examples of sectors that are traditionally good inflation hedges. They deal in products whose prices often rise as inflation rises and this works to their advantage.
Other stocks might not fare as well. Growth companies in their early stages with long-dated future cash flows as well as those carrying a lot of debt might face higher interest payments or be unable to take on new debt to finance needed growth. Retailers, especially if they’re selling discretionary items, may feel some pain if consumers pull back on spending. Overall, any business that faces higher input costs, lowered demand or both, might experience a decline in profit.”
Fixed income
Cash and fixed-income securities have traditionally had a harder time than stocks during high inflation periods and their returns can suffer. Cash, of course, loses value as time passes and price levels rise, meaning the same amount of cash will buy less. But higher inflation usually also brings higher short-term interest rates. This allows you to counteract some of the negatives of holding cash, or cash equivalents, if you hold it in a higher yielding product like a high interest savings account (HISA).
Existing fixed-income securities will likely experience price declines as rates move higher, and longer-maturity securities are likely to see greater price declines than shorter-maturity, all else being equal. This can be an issue if you want to sell the investment before maturity. But remember that your principal is returned when you hold the investment to maturity — except in the rare case of default — so price fluctuations along the way may not be a concern if that’s your plan.
On the positive side, newly issued fixed income will carry a higher interest rate, so investors buying these products as rates move up will benefit.
Should you adjust your portfolio when inflation rises?
It’s understandable that an investor might want to clarify why various investments rise or fall in response to higher inflation. However, it may not make sense to radically change your portfolio mix to try to capture those shorter-term moves. Asset prices often “look forward,” meaning that prices often adjust before the economic data tangibly shows that something is different. In addition, periods of higher inflation come and go and it’s always hard to know how close we are to the end of the current cycle. Overall, especially for longer-term investment goals, it makes sense to mainly tailor your portfolio choices to your own investment goals, with a focus on your risk tolerance and investment time horizon.
Calculating how much you’ll need to retire comfortably
If you’ve done any retirement planning and used a retirement calculator, you know that an inflation forecast is an important input to the “how much do I need to retire” calculation.
Retirement calculators estimate your retirement income in future dollar value. You’ll need to enter estimates for inflation and other variables such as your age at retirement, portfolio rate of return, how long the savings should last and so on. Here are the results using exactly the same assumptions but changing the estimated inflation rate.
The assumptions we’re using for this calculation:
- You’re retiring in 25 years at age 67 and your retirement will last 23 years.
- You want retirement savings to provide the equivalent in future dollars of 50% of your current income of 80k per year.
- Your sources of income will be withdrawals from this portfolio and government pension and related payments.
- Your portfolio returns will be 6% per year.
Assuming a 3% inflation rate — you’ll need about $679,000 in retirement savings by the time you retire in 25 years.
Assuming a 4% inflation rate — you’ll need about $946,000 in retirement savings by the time you retire in 25 years.
Changing the projected inflation rate changes the amount you’ll need at retirement and the effect can be quite dramatic. When inflation assumptions rise, your retirement nest egg needs to be larger. In effect, you’d need to invest more or capture higher investing returns along the way, or both.
While it makes sense to understand how higher or lower inflation can affect your retirement planning, inflation fluctuations tend to smooth out in the long run. In Canada, inflation has averaged between 3% and 4% in the long term1, even though it’s been close to 7% and near 0% for short periods. You should revisit your retirement calculations periodically or when your circumstances change. But you may only want to adjust the inflation number you use in the calculation if there’s a prolonged period of unusually high or low inflation.
Keep investing: As much as possible, allocate a portion of your savings to prioritize investing despite rising inflation. Techniques like Regular Investment Plans automate recurring deposits into your investment accounts and allow you to stay focused on long-term goals. You can set up Regular Investment Plans on the Investor’s Edge trading platform.
Understand how different investments are affected: Some stock sectors such as commodities and real estate have traditionally offered an inflation hedge, while other sectors can suffer due to higher input costs and lower demand for their products. Existing fixed income securities often decline in price as newly issued fixed income offers higher rates in a rising rate environment. Cash loses purchasing power faster during a period of high inflation, although higher-yielding short-term investment products can help counteract inflation’s impact. In general, your risk tolerance and time horizon should guide most of your portfolio allocation decisions rather than predictions about shorter-term asset performance.
Revisit longer-term investment goals: Inflation forecasts impact retirement savings needs, and higher inflation forecasts mean that you’ll need a larger retirement nest egg. You might consider adjusting your investment strategies and savings goals if higher or lower than usual inflation persists for a prolonged period. However, this is a relatively rare occurrence, as Canadian inflation has tended to return to its long-term average of 3% to 4%1.
