Inflation is the devaluation of money, i.e., the erosion of purchasing power over time. For many of us, inflation is manifested in the increase in the price of goods. From the items in your grocery cart to your costly restaurant bill or your dream home becoming further and further out of reach, inflation has a negative effect on our budget and our savings.
In the short term, inflation may seem benign and not very noticeable, but it can have a catastrophic impact on your financial planning if not addressed properly. It’s important to find strategies to immunize ourselves against the effects of inflation, especially as we plan for retirement. Here, we explain how common stocks allow your portfolio to counter the harmful effects of inflation.
Choosing Investments to Hedge Against Inflation
To protect your assets against inflation, you simply have to find securities whose return is greater than inflation. The real return is the net return minus inflation. In other words, if your common stock portfolio is yielding 8% but inflation is 3%, your portfolio’s real return is 5%. It is simply a matter of gaining ground against inflation by obtaining an additional return above its’ level.
Jeremy Siegel, a professor emeritus at the highly regarded Wharton School of Business at the University of Pennsylvania, has shown that real stock returns are remarkably constant over the long term, even during periods of inflation.
The results of researchers Jaffe and Mandalker also show that inflation has little effect on long-term stock returns.
Before we explain how common stocks allow investors to fight inflation, let’s look at other asset classes.
Bonds, Commodities, and Real Estate vs. Inflation
Apart from a few rare moments in history, bonds and fixed-income securities usually offer zero or very low real returns. Both asset categories are thus not ideal to allow our portfolio to fight inflation and generate a return that allows us to withdraw funds to live on our savings.
Commodities can act as an inflation hedge, however, they usually do not generate income or funds for portfolio withdrawals.
These asset classes, therefore, make it possible to defend against inflation, but the counter-attack is limited.
Real estate can be a good tool to fight inflation, but only if you meet certain conditions. Real Estate Income Trusts (REITs) are a good tool. They are, however, very similar to ordinary shares. The holder of a REIT is in fact the owner of a portion of a real estate portfolio whose objective is to generate income like common shares. We can therefore apply the reasoning of this article to this asset class.
Common Stocks vs. Inflation
We know an ordinary share is a property right in a company and in the profits it generates. We also know that the more money a company makes, the more it can distribute to its shareholders.
To understand how common stocks allow investors to hedge against inflation, one must first understand how their price is valued. The value of a common stock is defined by the sum of its future profits valued in today’s dollars. So if the expected future profits are on the rise, then the stock price should also show an uptrend.
In an inflationary context in which prices are rising, companies have the ability to pass on price increases to customers and consumers by increasing the price of the goods and services they provide.
When we increase selling prices to maintain profit margins, we also increase profits on an absolute basis. If profits are up, then the stock price should follow.
This is the mechanism that makes common stocks an excellent tool for fighting long-term inflation.
Although the mechanism is well oiled in the long term, the investor should also be aware that it is not so obvious in the short term, and that initially, one can even experience the opposite effect. There are three factors that prevent a perfect pairing between inflation and rising stock prices:
First, when inflation picks up, central banks will try to reduce inflationary pressures by raising interest rates. If interest rates are higher, this should theoretically make bonds more attractive to investors. Increases in interest rates will have the initial effect of making bonds more competitive than common stocks. With higher rates, a headwind is created for equities, since the latter’s supply-demand ratio will be affected. Investments will tend instead to favour the bond market, to the detriment of ordinary shares.
Second, since inflation causes interest rates to rise, the cost of capital becomes temporarily more expensive. It will cost more for companies to finance their new projects such as a new production line, a new factory or the acquisition of a competitor. This has the effect of reducing short-term profits and increasing the value of common shares.
Third, although companies may increase their prices to offset increasing costs, there is a certain amount of time before these increases pass through the sales cycle and move up the balance sheet. When the accounting and finance officers of a company notice an increase in cost, they will calculate an increase in the selling price to compensate. It is then necessary to announce price increases to customers and revise sales catalogues. Customers also have a grace period to pay their bills. The sums collected must be displayed in the income statements and then be published to the shareholders. This process must be completed before the markets realize with sufficient confidence that the company is navigating well in the inflationary environment and that profits are indeed on the rise.
Although inflation may seem harmful to the stock market in the short term, because of increases in interest rates – and the time required to complete a sales cycle, – inflation can actually be a good thing, allowing companies to increase prices and profit margins. Rising profits generally eventually support good stock market performance.
To hedge the negative effects of inflation, invest in a well-diversified portfolio. A well-diversified portfolio reduces the different types of risk and offers an optimal risk-return ratio.