How inflation affects investments: How to protect yourself?

Inflation affects investments

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There is a lot of talk lately about inflation, but how does inflation affect investments? We were not used to it after more than ten years where it seemed that, according to consumer price indices, central banks were not achieving, especially in Europe, that the two percent target mandated by the European Central Bank was reached. There was even some debate about whether it was necessary to rethink that objective and lower it to levels close to 1%. And suddenly, we wake up many days with double or triple inflation numbers in recent months.

What is happening? Before entering this debate, it should be remembered that inflation implies a continuous increase in the price level, not just a one-off rise in the form of steps in the prices of certain goods and services. It is therefore a burden on the purchasing power of an economy. It represents a recurring and constant devaluation of the purchasing power of families and companies, and therefore a variable that must be controlled for the correct preservation of assets when investing.

where does inflation come from

Inflation can come from a supply shock, which is limited for various reasons and results in higher prices than what is produced, or from a strong increase in demand. In this sense, and without an in-depth analysis, it could be concluded that the first case is much more negative, which also compromises the growth of the economy’s aggregate demand.

It can also be expected or unexpected for the main economic agents, which conditions their response in an economy that depends heavily on the “sentiment” effect. But what it always causes is a mismatch in certain markets, either by transferring resources from the lender to the borrower or from the company to the worker (or vice versa), which deviate from their equilibrium point, and that in the case of the labor market, causes an increase in unemployment.

In the case that concerns us now, an unusual characteristic that the pandemic has caused is that it has led to a considerable increase in demand, thanks, among other things, to the fiscal plans of the different governments, while at the same time drastically reducing supply. of goods and services with lockdowns and factory closures. The combination of both effects has led to price increases of over 4%, in addition to certain disruptions in the supply chain as we can see in the media.

Inflation affects investments

A wave of inflation: transitory or persistent?

This wave of inflation is very likely to be transitory. Why? Because to the extent that part of that fiscal boost to spending is attenuated and supply chains are normalized at some point not too far away, that continued increase in prices ceases to exist, and therefore does not require any action in terms of policy. monetary policy by central banks.

In other words, the rise in second-hand car prices should reverse in a few quarters. Something similar should be expected from the energy and electricity markets. But it is possible that a second wave will arrive, more closely linked to the service sector (which weighs three times in a developed economy) and that will affect the rise in wages, which is the main component of the rise in business costs. Here inflation tends to be more persistent, and could be a real problem for the economy and a headache for monetary policy.

Therefore, we may be facing a higher inflation scenario than the leading economists were forecasting just a few months ago. Longer -lasting inflation pushes real interest rates further into negative territory, making economic policy even more ultra accommodative, putting pressure on the Central Bank to scale back its asset purchase program and eventually raise benchmark interest rates.

The impact on financial markets

The reality is that the impact of inflation in financial markets is negative for nominal investments such as fixed income, but in equities it is very uneven. The asset or sector that has historically best protected against inflationary environments has been that of raw materials, including oil (which are the assets that accumulate the most increases in the year, by the way). Gold, facing negative real interest rates, also tends to perform well. But the fundamental thing in equities is to find companies with the capacity to set prices and that can transfer this increase in costs to final prices without the demand suffering too much.

Lastly, the real interest rate differential between two economies tends, in the short term, to largely explain the relative evolution of their currencies. In other words, while it seems that both inflation and the Federal Reserve’s response are being somewhat more forceful in the US than in the Eurozone, it will be difficult to see the euro appreciate against the dollar in the short term.