Inflation rate
Signs of inflation rising in key economies worldwide – how will it hurt your money? Image Credit: Shutterstock

Dubai: There has now been increased talk about the possibility of inflation looming as prices of goods are rising in top economies – a natural transition for countries everywhere after billions were spent to buoy economies amid a pandemic-induced health crisis.

As a result, investors are currently witnessing a tremor within inflation-linked bond markets (a relation that is explained below). So many are questioning, how and why this shake-up seen with their fixed income investments will affect their portfolio of hard-earned savings.

Adding to such woes, global stock markets are currently witnessing a major selloff, which worries investors who have especially been investing in international markets for the first time.

Moreover, experts see stocks volatile till the above-mentioned turmoil in debt markets settle down. But first, how does inflation affect your investments.

How is inflation linked to market investments?

Inflation, which a decrease in the purchasing power of money and reflected in a general increase in the prices of goods and services in an economy, lowers the value of cash savings and fixed-income investments.

When inflation rises, consumers can purchase fewer goods, input prices go up, and revenues and profits go down. As a result, the economy slows down until stability returns. High-interest rates and companies raising prices don't add up to an investment profile most investors enjoy.

Valuable stocks perform better in high inflation periods and stocks with growth-potential perform better during low inflation. When inflation is on the upswing, income-oriented or high-dividend-paying stock prices generally decline. Stocks overall do seem to be more volatile during highly inflationary periods.

How does this affect your buying power?

An economic concept, the rate of inflation is important as it represents the rate at which the real value of an investment is eroded and the loss in spending or purchasing power over time. So, if your income doesn't increase by at least the same rate of inflation, you will not be able to buy as many products.

So, although investors are yet to see any evidence of inflation worldwide, as governments worldwide continued to inject billions to keep economies afloat, the cash-injection will eventually reduce, leading to an extended period of higher interest rates and as a result, inflation.

How inflation erodes your money

Every rise in prices is taking money from your pocket, or your portfolio. With 2 per cent inflation, a pack of biscuits that costs Dh1 today will cost Dh1.02 in a year. The higher the rate, the greater the erosion, exacerbated by the effect of compounding.

How the power of compounding affects your money?
Compound interest occurs when interest gets added to the amount invested or borrowed, and then the interest rate applies to the new (larger) amount.

Compounding can work to your advantage as your savings and investments grow over time - or against you if you're paying off debt.

Savings of Dh100 would be worth a mere Dh36 in real terms in 20 years if inflation sits at 5 per cent, or Dh82 at a level of 1 per cent.

How inflation can affect an investment portfolio

The aim of investors is to grow their money at a rate that will meet their goals, and comfortably exceed inflation.

Although more volatile, stock market investments have historically performed well, benefiting from the earnings of companies usually rising along with inflation and when dividends are re-invested. It is these dividends that help in the battle to beat inflation, particularly when returns compound.

Why are inflation expectations rising?

For the first time since the global financial crisis, inflation expectations have risen above that what was seen over the last five years. Though currently small, it indicates that investors are beginning to consider a return of inflation over the medium term.

A year ago, markets were in the grip of the coronavirus crisis. Stock markets were tanking and central banks were embarking on aggressive interest rate cuts and other stimulus measures to steady the financial system.

What happened to prices of safe-haven assets?

What happened to what is widely perceived as safe-haven investments or fixed income assets (like bonds), was that it sent prices rocketing, pushing yields to rock-bottom levels. (Bond yield is a return on investment, expressed as a percentage, for a bond, i.e. interest rates offered by bonds. The yields are inversely related to prices. The lower the price, the higher the yield.)

Now, the current pressing issue for investors is that those bond prices have been falling back and yields are rising. Some hedge funds are raking in big returns. But other institutional investors are fretting that it could yet seriously destabilise markets.

What is bond yields? How are bond prices and bond yields co-related?
The bond yield is a return on investment, expressed as a percentage, for a bond (i.e. interest rates offered by bonds). The yields are inversely related to prices. The lower the price, the higher the yield.

Where are prices seen inflating?

Although serious consumer price rises are not evidently visible just yet, with the global economy still inching out of pandemic-related uncertainty, investors and veteran investors have good reason to think it could start to bite soon.

Commodity prices worldwide have already shot higher in anticipation of a global economic recovery. Copper has hit its highest price point in a decade. Oil is back above $60 (Dh220) per barrel, having erased the coronavirus-induced shock.

Is inflation bad for my so-called ‘safe’ investments?

It’s bad news for investment holdings in bonds. Bond prices have been sky high, thanks to the massive monetary stimulus launched by central banks seeking to soften the blow of the pandemic. But the pullback at the start of 2021 has been fierce as investors try to price in inflation before it happens.

Inflation hurts bond market investments because it eats away at the real value of the fixed interest payments, and it could force the hand of inflation-targeting central bankers into limiting their stimulus.

One reason why stock markets have been rallying strong in recent months, despite the economic impact of coronavirus, is that bond yields are so low. But the danger is that with yields picking up, some parts of the stock market might suffer. Analysts have seen this, particularly with top technology stocks.

Is your investment portfolio protected?

The classic split for an investment portfolio is 60 per cent equities, 40 per cent bonds, which operate under the premise that as one asset class falls, the other usually rises.

However, as yields have sunk so low that they offer little scope for further gains if stocks take a knock. This recent pick-up in yields provides a little more padding.

Experts evaluate that central banks will step up to prevent bonds falling too far, too fast, then bonds should continue to offer a little comfort in the event of a rapid descent in stocks.