Impact of inflation on investments

Inflation is a silent financial force that can significantly affect our investments and overall financial well-being. As prices of goods and services rise over time, the purchasing power of our money diminishes.

This erosion of value has a profound impact on various investment avenues, making it crucial for investors to understand and plan for inflation’s effects.

Inflation has risen significantly in South Africa and globally since the Covid-19 pandemic on the back of constrained supply chains, government stimulus packages, low interest rates, rising oil prices and labour shortages.

The trajectory of South Africa’s headline inflation rate has been shaped primarily by fuel, electricity, and food price inflation.

Inflation in South Africa peaked in July 2022 at 7,8 percent, well above the 4,5 percent target of the South African Reserve Bank (Sarb).

The above target inflation rates have resulted in an increase in interest rates in an effort by the Sarb to bring inflation down. Fortunately, inflation has been decreasing gradually since the peak in July 2022, with the latest figure for June 2023 CPI (Consumer Price Index) coming in at 5,4 percent .

In this article, we explore the impact of inflation on investments and discuss strategies to preserve wealth in an inflationary environment.

Erosion of purchasing power: One of the most direct impacts of inflation on investments is the erosion of purchasing power. As inflation increases, the same amount of money will buy fewer goods and services.

This means that even if your investment portfolio grows in nominal terms, its real value might decline when adjusted for inflation.

For example, if your investments yield a 5 percent return, but inflation stands at 3 percent, your real return is only 2 percent .

Fixed-income investments: Fixed-income investments, such as bonds, are particularly vulnerable to inflation’s impact.

When you invest in a fixed-income security, you are essentially lending money to an issuer in return for periodic interest payments. However, if inflation rises during the investment term, the purchasing power of those interest payments decreases.

Additionally, when the investment matures, you might find that the principal amount can buy fewer goods and services than when you initially invested.

Equity: While equity is generally considered a hedge against inflation, its performance during inflationary periods can still be affected. Inflation can lead to higher production costs, reducing profit margins for companies.

Moreover, companies may struggle to pass on these increased costs to consumers if their products or services face price sensitivity. As a result, a high and sustained inflation rate can negatively impact corporate earnings and, consequently, stock prices.

Property: Property is often considered a reliable hedge against inflation. During inflationary periods, the value of properties tends to rise, preserving the investment’s purchasing power.

Additionally, property can provide a source of passive income through rent payments, which may also increase with inflation. However, it is essential to note that real estate’s performance can vary based on local market conditions and other economic factors.

Four strategies to preserve wealth

Diversification: Diversifying your investment portfolio across different asset classes can help mitigate the impact of inflation. While some assets may suffer during inflationary periods, others may perform well, reducing overall risk.

Inflation-indexed securities: Consider investing in inflation-indexed securities, like Treasury Inflation-Protected Securities (TIPS).

These investments adjust their principal value based on changes in the CPI, ensuring that your investment keeps pace with inflation.

Equity investments: Despite potential challenges, equities have historically outperformed inflation over the long term. Companies that can adapt to inflationary pressures are likely to maintain or increase their value over time.

Property: Property, especially physical property, can function as a valuable hedge against inflation due to its tangible nature, appreciation potential, ability to generate rental income and its relatively low correlation to traditional assets.

In addition to property, consider investing in tangible assets like precious metals, commodities, or infrastructure projects. These assets tend to retain value during inflationary periods.

Conclusion

Inflation is an erosive factor that negatively impacts the value of investments. Its eroding effect on purchasing power underscores the need for investors to plan and strategise accordingly. Diversification, inflation-indexed securities, equity investments, and real assets are all valuable tools for preserving wealth in an inflationary environment.

By understanding inflation’s impact and implementing prudent investment strategies, investors can navigate inflationary periods and achieve long-term financial success. Remember, staying informed and seeking professional advice can make a substantial difference in safeguarding your investments against the ravages of inflation. — Moneyweb