Hi Financial Friends! Inflation has been red hot lately and it’s been an even hotter topic in the markets as a result. Inflation is when prices are increasing, but this is only one side of the coin.
Deflation, on the other hand, is when prices are falling. The economy can flip flop between inflationary and deflationary environments and too much of one or the other can be bad news for the economy. That’s why central banks keep a close eye on things and try to keep inflation and deflation in check with monetary policy.
For example, when inflation is running too hot, the central bank will hike interest rates. Inflation and deflation affect everyone, but how do they impact you as a retail investor? Let’s take a look.
So we know that inflation is when prices rise, but why does it happen in the first place? Inflation is usually caused by high-demand or by demand that’s outpacing supply. While rising prices may seem like a pain for consumers, it also means there’s a lot of spending in the economy which is a good a good thing.
When it comes to investing, the effects of inflation don’t go unnoticed. For starters, inflation can cause more volatility in the markets which can have a huge emotional impact on investors as they see the value of their investments swing up and down. Inflation impacts all types of investments, and while it’s true that investing in the stock market can protect you against inflation, there are certain types of stocks that tend to fare better than others when we see inflation.
Because inflation means rising prices, consumer goods stocks, energy stocks, and even financial stocks (because they get to charge higher rates on mortgages, credit cards, and other loans) usually perform well when we see inflation. The stocks that tend to underperform during times of inflation are growth stocks. This is because the value of a growth stock is typically based on future cash flows. Rising interest rates that are implemented to reign in inflation, can reduce a growth stock’s future earnings, which will typically have a negative impact on the stock’s price.
While it’s true that some stocks perform better than others in times of inflation, it doesn’t mean you have to do a total portfolio overhaul or completely boycott growth stocks. Inflation comes and goes and having a well diversified portfolio is what will help you weather the storm.
Now let’s take a look at the flipside. Deflation is when the prices fall, which may sound like a good thing for consumers, but the pros of deflation don’t usually outweigh the cons as deflation often means a recession is on the way. Opposite to inflation, deflation is caused by excess supply which results in lower prices as an incentive for consumers to spend money.
As an investor, defending yourself against the negative effects of deflation is more difficult than with inflation. Decreasing demand can be a huge problem for stocks and investors tend to lean towards more defensive investments as a result. Bonds become a more popular investment as they typically hold up better than stocks in a deflationary environment. Not all equities are doomed though. Investor’s tend to favour defensive positions like dividend stocks or consumer goods as they sell things that people need to buy regardless of the inflationary conditions.
Another big factor that comes with deflation is falling interest rates. Interest rates are low when we see deflation to try to get people to spend and borrow money. This typically leads to people saddling themselves with debt. Taking out a loan or getting a mortgage with a super low rate may seem great, but this is only the case if you’re getting it at a fixed rate. Fixed rate means the rate on your loan will not change. Variable rate loans can bite you in the butt because they may have an attractive rate when you take the loan out, but if that rate goes up down the road, you may end up owing a lot more money than you originally thought.
Wrapping it Up
While too much inflation can be a problem and deflation is usually a sign of bad things to come, most central banks favour inflation, typically shooting for about 2 or 3% inflation every year. As an investor, you’re already ahead of the game in terms of protecting yourself against inflation. The stock market typically outperforms inflation and if you take it a step further by having a well diversified portfolio, you’ll be protected better than most.