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With very few historical exceptions, the price of goods and services rises as time passes. Anticipating inevitable inflation, or responding to short periods of rapid price increases, is essential to a comprehensive, long-term financial plan.
Accounting for inflation will protect future purchasing power since one of the base goals of retirement investments is protection of assets and maintaining their value. Over twenty years 2% annual inflation will increase prices by 49%, and 3% inflation will increase prices by 81% after twenty years.
Since some investment vehicles respond better during inflationary times, and others typically do not, balancing your portfolio and accounting for inflation should be included in the planning process.
What You Need to Know
Starting after the early days of the pandemic, inflation levels have been well above the targets set by central banks, and four years have passed with heightened interest rates before inflation began to approach pre-pandemic levels.
The Consumer Price Index (CPI), the primary measure of Canadian inflation, is a standardized basket of goods representing the purchasing habits of a typical individual. Core CPI removes more volatile, and often geopolitically influenced, energy and food. Both CPI and Core CPI are calculated monthly and annually to determine price changes. The “year-over-year” measures are typically the most quoted and most utilized for assessing price stability.
The Consumer Price Index (CPI) has been outside the Bank of Canada’s target range for almost every month since March 2020. Most Canadians have forgotten that the early days of the pandemic brought a tremendous slowing of economic activity, and for several months the CPI was below the Bank’s target range. Once supply chain issues surfaced, inflation rose rapidly passing through the 1-3 percent goal range and peaking at 8.1% in June 2022.
During periods of high inflation, different types of investments, or asset classes, react differently. Equities, fixed income, cash and cash equivalents, real estate, commodities, and currencies are examples of asset classes. Constructing an investment portfolio with a variety of asset classes can provide diversification to mitigate down-side risk. Also, within each asset class additional opportunities to diversify exist. For example, equities from various sectors (financial, energy, technology, etc.) or geographies (i.e. developed countries) could lower risk.
Each investor has a unique financial situation and will, therefore, require a unique solution. The principles to construct an individualized portfolio persist during periods of high inflation, which supplies additional pressure, uncertainty, and complexity to each asset class. Each type of investment is affected differently, and instruments within an asset class can respond uniquely. The guiding principles for asset classes during inflationary times are as follows:
- Equities or stocks offer an intriguing investment opportunity during periods of higher than normal inflation. Since inflation represents an increase in prices for goods and services, some companies are able to adjust their prices upward, while others do not. Grocery store chains, car dealerships and restaurant meals often pass along price increases from their suppliers to their customers. Other industries, like utilities with long-term projects or regulated price increases often find raising prices more difficult.
- Fixed Income investments, like corporate or government bonds, usually provide specified rate of return for the term of the investment. Since the cost of living is increasing when inflation rises, the standardized payments have their purchasing power eroded. Additionally, some fixed income investments are bought and sold on the secondary market, which means their price fluctuates in response to prevailing rates. Often with inflation high or rising, interest rates rise, and bond values will fall to provide second-time owners with yields similar to current/prevailing yields. Some more complex bonds offer returns indexed to inflation but are not widely held by retail investors compare to other types of bonds.
- Real Estate values and rental charges often rise rapidly during the early days of inflation cycles. Investors who have directly purchased real estate, or indirectly through a real estate investment trust (REIT) fare well when prices rise broadly. Once interest rates are raised to combat inflation the demand from new purchases of existing real estate tends to stall along with real estate values.
- Commodities also tend to rise with inflation since they are tangible assets needed for industrial production. Precious metals, raw materials and agricultural products tend to move in-concert with inflation.
- Cash is the unused portion inside a portfolio. Although there is little risk to holding cash, its value is eroded by inflation as purchasing power declines.
A balanced portfolio typically contains many, if not all, of these asset classes to provide diversification which can lower investment risk. An overall projection on risk and returns provides a measure of preparedness for retirement. Not including a projection of inflation into a financial plan will leave investors vulnerable to price increase and purchasing power decline.
The Bottom Line
For many investors the correct course of action during the most recent period of high inflation was inaction. Interest rates had been at all-time lows, which diminished the size of fixed income holdings within investors’ savings. Since the asset class, fixed income, with one of the worst performance histories during inflation had been reduced in many portfolios there was no reason to retreat further. Holding some fixed income provides a measure of risk mitigation through diversification, and further reducing GICs and bonds could raise risk in some cases.
Many investor portfolios held mostly equities, which performed well over the past four years of high inflation. The early days of the pandemic delivered losses to equity investors. Those losses were quickly reversed in most cases, and a prolonged period of gains followed, especially for U.S. equities.
Once the Bank of Canada and other central banks like the U.S. Federal Reserve, European Central Bank and Bank of England, started raising interest rates to curb inflation many markets began changing, especially real estate. Interest payments on mortgages rose faster than rents and prevented many from investing in income property. Higher mortgage rates translated into higher payments, which many struggled to afford. Many potential buyers were priced-out of the market. Property values, which had risen quickly, stabilized once interest rates tempered demand.
It may seem that much has changed, because it has, but a well-constructed portfolio can withstand pressure and survive, if not thrive when it is constructed to account for inflation.
