For the last decade economies and investors have been operating in a low inflation environment which has generally been good for investors. In recent months, however, rising inflation has emerged as a threat.

Why does inflation matter?

 Inflation means increased input costs for businesses. For example, higher commodity prices mean manufacturers have to pay more for the materials they use to produce their goods, which means they either have to increase the prices they charge for the goods they produce, or they suffer from tighter profit margins.

Inflation means increases in the cost of living for consumers. Consumers can purchase fewer goods, and they have to pay more for those goods. Unless wages keep up with inflation, this results in a lower standard of living.

Higher rates of inflation have an influence in their own right, but just as important, they tend to be accompanied by, or result in, increasing interest rates, which can also have a significant impact.

Governments typically use higher interest rates as a measure to combat rising inflation. High inflation is seen as a sign of an overheating economy, and in response central banks often tighten monetary policy (increase interest rates) in an attempt to dampen economic activity.

A moderate level of inflation is seen as a sign of a growing economy. In New Zealand, the Reserve Bank have agreed that the appropriate target for monetary policy is to achieve an average inflation rate of 2% over time.

How does inflation affect investors?

Inflation eats up the value of money for everyone.

For example, if you invest in a term deposit paying 4% p.a., and inflation is 2% p.a., your real return is 2% p.a. A higher inflation rate means you have to earn a higher rate of return simply to break even in real terms.

While modestly rising inflation is generally seen as a positive for the broad sharemarket, as it is consistent with an economy growing at a sustainable pace, inflation above a certain level, or unexpected jumps in inflation, can be a negative. The impact may however vary for different sectors, and for different investments.

Higher inflation is usually seen as a negative for stocks because it typically results in:

• Increased borrowing costs
• Higher costs of materials and labour
• Reduced expectations of earnings growth.

Taken together, these variables generally put downward pressure on stock prices.

Are all stocks affected the same?

The answer to this question is – ‘No’. There are some sectors that have the potential to outperform in inflationary environments.

For example, people need to eat, regardless of whether inflation is rising or falling. Investors can consider exposure to agricultural commodities and food producers in an inflationary environment.

If rising inflation is accompanied by increases in the prices of commodities such as iron ore, this will have a negative impact on the purchasers of those commodities – but is likely to benefit commodity producers such as iron ore miners. Similarly, if there is an associated increase in the price of oil, an exposure to energy producers may provide defensive benefits.

Value Vs growth stocks

Inflation has generally tended to affect growth stocks more than value stocks.

A common method used to value stocks is the discounted cash flow (DCF) method. Essentially, DCF values an investment based on its future cash flows. It involves calculating the present value of expected future cash flows, by applying a ‘discount rate’ to those future cash flows, to arrive at a valuation. The discount rate is dependent on interest rates – the higher the rate, the lower the present value of future cash flows, and therefore the lower the valuation attributed to the investment.

The other relevant point is that the further into the future a cashflow occurs, the lower the present value of that cash flow will be. Many growth stocks have relatively low cash flows now but are expected to generate significant flows in the future, while many value stocks have strong cash flows now, but are expected to grow at a slower pace, or even decline.

Increases in inflation and interest rates are therefore likely to have a higher impact on growth stocks than on value stocks, as the cashflows their valuations are based on will be discounted more.

Fixed income investors

Rising yields (interest rates) are bad for fixed income investments that pay a fixed rate of interest, such as bonds, for two reasons.

Firstly, there is an inverse relationship between a bond’s price and its yield, as interest rates increase, bonds fall in value, so bond holders can face capital losses.

Secondly, the income stream from fixed rate bonds remains the same until maturity. As inflation rises, the purchasing power of the interest payments declines.

Investments that pay a floating rate of return are likely to be better off in an inflationary environment, as the interest rate they pay is adjusted periodically to reflect market rates.

Inflation is generally regarded as damaging to holders of cash and cash equivalents, since the value of cash will not keep up with the increased price of goods and services.

 Source: Montgomery Investment Management