How to Prepare for Inflation

Inflation, like death and taxes, is a phenomenon that experts expect will occur over a period of time. Although the U.S. has gone through brief periods of deflation, economic growth tends to be accompanied by inflation. Inflation is only neutralized if the 2 primary sources of wealth creation — income and assets — rise at a rate faster or equal to overall inflation. 

Inflation does not rise at a constant rate and can sometimes jump, as seen recently when COVID-19 restrictions were lifted and economic activity resumed in the U.S. In order to protect your assets, returns and dividends, it is important to prepare yourself for inflation. The Federal Reserve projected that inflation woule rise by 4.2% in 2021, which illustrates the need to shield your assets from rising prices. At the same time, the Federal Reserve could not have imagined inflation soaring past 8% in late 2022 and into 2023. This is why all investors must be prepared for inflation and its effects.

How Does Inflation Affect Investors?

When inflation is rising, assets with long-term cash flow tend to perform poorly as cash in the future is worth less than it is today. Conversely, property rental income tends to perform better with higher inflation. 

Savings

Inflation can shrink your savings, even if you get a fixed rate, as your earnings will not keep pace with inflation. This situation is especially bad if you retire and live off your savings as inflation diminishes your purchasing power. 

Fixed income investments

Investors buy fixed income securities such as bonds, treasuries and CDs because they want steady returns in the form of interest payments. However, the purchasing power from these interest payments declines as inflation rises. Consequently, bond prices tend to fall when inflation rises. Higher inflation is even worse for long-term bonds because of its impact on cash flows that will be lower in the future. However, high-risk bonds tend to provide more of a cushion than their investment grade counterparts during periods of high inflation. 

Stock investments

Stocks do not always perform well when inflation is rising. Higher inflation usually causes the central bank to raise interest rates, which in turn increases borrowing costs for firms, while high inflation reduces the purchasing power of households. However, not all stocks perform poorly during periods of high inflation. Profits are usually the spread between wholesale and retail prices, and rising inflation requires higher levels of working capital. During inflationary periods, this spread includes the inventory and the price increase. As such, real estate stocks tend to perform well when inflation is rising, while retailers that hold huge inventories tend to lose out.

Meanwhile, commodity prices usually rise disproportionately with higher inflation. For example, a copper mining company may enjoy higher profits while processors and manufacturers may be badly hit by higher costs before increasing their prices. Although the margins won’t change much, it could be more complicated to forecast or predict financial performance, which causes volatility in share prices. 

Higher inflation and economic volatility share a strong relationship. Greater variations in the economy will hurt companies that tend to be more volatile, including construction, capital goods and durable consumer goods. However, relatively stable industries such as healthcare will not be greatly affected by rising inflation. 

In summary, inflation helps commodities and real estate while hurting industries with high inventories. However, the worst impact of inflation will be from interest rate hikes from the Federal Reserve and not from the direct impact of rising prices alone. 

How Do You Prepare Investments for Inflation?

When inflation rises or is set to rise at a faster pace, you should take action to protect your investments. One example could be diversifying into commodities and real estate and away from retail to ensure that your returns are not badly hit by inflation. You can invest in inflation-proof vehicles that protect your returns from rising prices. 

What is an Inflation-Proof Investment?

Inflation-proof investments are assets that are not exposed to rising prices. Instead, their value tends to increase as prices of goods and services rise. 

Types of Inflation-Proof Investments

Inflation can make a significant impact on a portfolio over time. You can take 2 steps to reduce the effect of inflation on your investments. Diversifying your portfolio into commodities and real estate can have an overall positive impact on your returns. 

Money Market Funds or TIPS

Money market funds can reduce your exposure to inflation. For example, in the week ending October 1, 2021, data from Lipper revealed that, globally, investors bought $13.95 billion in money market funds, compared with a net sell-off estimated at $21.85 million in the previous week. Meanwhile,  Treasury inflation-protected securities (TIPS) issued by the U.S. government can protect you from rising inflation. However, the incomes and returns from TIPS tend to be low. 

Real Estate

Real estate companies generally benefit from inflation even as mortgage rates tend to be fixed. Rising costs will be balanced by rising prices, but property managers with a large stock could face a few inflation-related problems. However, landlords can raise the prices of rent in line with inflation, which provides a hedge against inflation over the long run.

Equity Investments

Higher inflation tends to boost nominal GDP and ultimately stocks. However, it is important to pick stocks that are not exposed to inflation such as oil or property companies. Stocks that have high inventory such as manufacturing or retail tend to be badly hit by inflation. 

Commodities

Commodities provide a good hedge against rising inflation. In some cases, commodities contribute to higher inflation, which provides a rationale for holding them during inflationary periods.

Fixed-Rate Debt

Fixed-rated debt pays a specific interest — called the coupon — over the duration of the asset. However, high-yield bonds tend to perform well during periods of too-high inflation even as they are more volatile than traditional bonds. 

Below, Benzinga provides a list of brokerages to help you invest better during periods of high inflation. 

Hedge Against Inflation to Enjoy Steady Returns on Your Investments

Inflation is uncertain, and while it may be out of your control, you should take steps to protect your investments, assets and returns. Actions such as diversifying your portfolio into TIPS, ETFs, commodities or real estate are a good way to ensure that you benefit from your investments when inflation is rising. Come over to Benzinga Pro for more information on how to protect your assets from inflation and benefit from real-time market intelligence. 

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