Inflation is at a 40-year high and many investors are concerned with how rising prices and higher interest rates could impact their portfolios. It is true that inflation could have an effect on your investing strategy but overreacting to it can create bigger problems. So, instead of taking drastic action, work with your advisor to understand how inflation impacts your plan and what steps you can take to mitigate these impacts without losing sight of your goals.
How Inflation and Rising Rates Impact Bonds
The amount of income that bonds produce is fixed. In other words, bonds pay the same amount of income to investors regardless of market conditions. On the other hand, the price paid to purchase bonds will vary based on changing market conditions, like inflation.
When inflation is high, bond investors typically demand higher yields to compensate for lost purchasing power. This means that new bonds are issued at higher rates – which equates to lower purchase prices. Since bond investors have the option to purchase new bonds at lower prices (with a higher rate of return), older bonds can become less attractive until their price drops to match market rates of return.
Although older bond prices typically fall when new bonds are issued at a higher rate, bond investors could see higher income in the long run from their bond holdings. This is because bond investors often replace their bond holdings when they mature with new bonds of a similar risk and term. In a rising rate environment, these new bonds would have a higher yield and generate more income in the long run.
How Monetary Policy Impacts Bond Prices and Yields
Interest rates are often the largest factor impacting bond prices. In periods of high inflation, the Fed will often raise the Federal Funds Rate in an attempt to cool the economy, and market interest rates generally follow. When this happens, bond yields rise / bond prices fall in response.
In 2022, the FOMC is expected to raise rates several times to combat historically high inflation. So, in the absence of other economically impactful events, investors should expect bond prices to decline and yields to rise throughout the year in response to these rising rates.
How Inflation and Rising Rates Impact Stocks
The effects of inflation on stock performance are highly dependent on asset class, industry, and business structure. Typically, when inflation is high, so is consumer demand. This can lead to more sales and higher revenue for some companies, which can in turn have a positive impact on their stock prices.
On the other hand, higher prices often equal higher input costs. These higher production costs can cancel out the gains produced by higher consumer demand. In this case, companies must either raise prices – worsening the inflation cycle – or absorb the price increase through reduced profits. This can have an adverse impact on stock price.
How Monetary Policy Impacts Stock Prices
When leaders raise interest rates, it can dampen consumer demand, though the effects are often uneven across industries. In addition, a rising rate environment can reduce the likelihood that consumers make large purchases that require financing – which could impact sectors that make such products. Both of these factors can reduce overall demand for products and lead to lower sales – and therefore lower stock prices.
Conversely, there are some sectors that create products or services that are necessary, regardless of their price, like food and energy. These sectors are less likely to be impacted by rising rates. This is one of the reasons why value stocks tend to outperform growth stocks in a high inflation environment.
In addition, there are other sectors where prevailing interest rates determine the earnings of the company, like the banking sector. That’s why higher rates can often be a boon for banking stocks.
Finally, growth stocks can be the most heavily impacted by rising rates. This is due to the way growth stocks are valued in the marketplace. In short, these stocks are valued by determining the real, current value of their anticipated future cash flows. This calculation is heavily dependent on the prevailing risk-free investment rate (e.g. a 3-month Treasury Bill). So, as those rates rise, the calculation for the value of the future cash flows can drop dramatically – and therefore the stock value. This is why investors often shift their investments away from ‘growth’ stocks and toward ‘value’ stocks in these environments.
How Diversification Mitigates the Impacts of Inflation and Rising Rates
As detailed above, some securities react positively to inflation while others lose value. With a properly diversified portfolio, your investments will react to inflation in different ways that work to cancel out the negative effects. That’s why a properly diversified portfolio is the best way to mitigate inflation risk.
Throughout history, a well-diversified portfolio of traditional investments has outpaced inflation. In fact, since the Great Depression a balanced portfolio has yielded 8.50% annual returns while inflation has averaged 3.08% a year.
Despite this long-term success of diversified portfolios, investors are often tempted to change their investments when faced with high inflation or other destabilizing market forces. That’s why it is important to remember that market timing rarely works and attempting to time the market often leads to lower returns in the long run.
Protect Your Savings from Inflation with Financial Fingerprint™ by Meld Financial
Inflation can be alarming, but it isn’t a new phenomenon. An experienced advisor should take inflation into account when determining your required rate of return, your portfolio construction, and your future income needs. At Meld Financial, our advisors consider the current inflation rate and future inflation scenarios when developing your Financial Fingerprint™.
Financial Fingerprint™ was developed at Meld during over 30 years of managing our clients’ wealth. It is a customized wealth management plan that is quick to assemble, easy to understand, and simple to modify as your circumstances change. The best part is Financial Fingerprint™ accounts for inflation at every step of the retirement planning process.