Updated: May 3, 2022
As inflation continues to skyrocket around the globe, here’s how IFAs can help investors adjust their portfolios and hedge against risk.
Understandably, high inflation is one of the biggest concerns for investors right now. While Covid already caused the markets to spiral out of control, the conflict in Ukraine has only exacerbated the economic and fiscal uncertainty to the point where food, commodities, gas, and energy are now at a 40-year record high.
In the UK, the consumer price index (CPI) has been at its highest since 1992, seeing an increase of 6.2% in the 12 months leading up to February, up from 5.5% from the previous month. The US was hit even harder, with interest rates increasing from 0.25% to 0.5% in February and a 7.9% increase in the CPI, which doesn’t even take into account the sanctions imposed on Russia or the flow of arms and aid to Ukraine.
With events forecasted to become exponentially worse over the coming months, now is a good time for financial advisors to be proactive in engaging with clients over the effects inflation could have on their investments.
How Does Inflation Impact Fixed-Income Assets?
For certain types of investment, inflation can have a long-lasting negative effect. The performance of certificates of deposit, treasury bills, government bonds with a long maturity and other types of fixed-income assets can all be hurt by inflation because the rise in prices and expected future interest rate hikes create a higher yield curve, indicating a potential reduction in investor returns and a weakening of purchasing power.
Returns for investments on governments bonds also tend to fall when inflation rises, and newer, higher-rate fixed-income instruments cause rates to become less competitive. In other words, increased inflation rates can cause the value of these investments to shrink because of the inverse relationship between government bond values and interest rates. If a central bank raises interest rates after an investor has just purchased a 5-year maturity bond, they can expect heavier losses compared to a short-term bond where only a year’s worth of coupon payments are needed for it to mature.
How Are Corporate Bonds Different?
While secured corporate bonds have a higher risk profile than banking or government bonds, the returns and rewards can be much higher because these bonds are backed up by collateral; warehouses, factories and industrial equipment. Such assets help companies fulfill their debt obligations when inflationary pressure sets in, enabling them to recover quickly if they default or breach a bond covenant.
Holders of debentures or unsecured bonds, on the other hand, are relying on good faith as these issuers have no collateral and are only backed up by their credit rating. As a result, any unsecured debt only gets paid off once the higher-ranking debt is paid, i.e., those with senior secured debt.
Unlike stocks and shareholders, secured corporate bondholders are also the first on the “investor hierarchy ladder” to be paid off in the event a company defaults. They are also more likely to get a portion of their investments back if a company goes bankrupt or into liquidation.
What Are the Effects on Equities?
Inflation can have a mixed effect on stocks and shares. When the economy is strong, inflation is typically high. But even though companies are supporting their share prices by selling more products and services, they may be simultaneously increasing costs in their business by paying out more for raw materials and staff salaries.
While gold and precious metals still fluctuate in price, they are more of a safe haven investment because they are less vulnerable to inflationary risk and are essentially “insured” against political, financial, and military upheaval. Unlike paper money, it’s not possible to simply “print more” gold; therefore, when a currency declines, gold only increases in value.
How Does It Impact Savings?
Because prices typically continue to rise long after the initial shock, inflation can noticeably reduce the value of cash savings over time. If a client has $20,000 locked away in a safe at home, this money won’t be worth as much in 20 years. This gives the client a smaller net worth because inflation is eroding the value of this money and eating into their purchasing power.
While a client can put this money in a bank account to earn interest and offset some of the effects of inflation, it won’t be able to outgrow it entirely. This is why investments with higher growth, such as mutual funds or equities, may be a better option because, on average, they earn more per year than the rate of inflation. They also carry fewer risks when it comes to lower or complete loss of earnings.
How IFAs Can Support Clients In Times of High Inflation
In the current economic climate, now may be a good time to point investors toward low-volatility options like convertibles that combine bonds with equities or bonds that are secured by corporate assets. Financial advisors can also help clients diversify and mitigate the effects of inflation through investments like interest rate swaps and inflation-linked bonds. These contract investments help protect clients from the adverse effects of inflation by linking the bonds’ interest payments and principal to a nationally-recognised inflation index like the Consumer Price Index (CPI) in the US, the Retail Price Index (RPI) in the UK, and the European Harmonised Index of Consumer Prices (HICP) ex-tobacco in the EU.
Despite sky-high house prices, mortgage interest rates hit record lows in 2021, with some coming in as much as 1% in the UK. Though these rates have and are expected to continue to climb over the coming months, real estate could also be an effective means for hedging against inflation in 2022. Of course, taxes and other expenses may also rise this year, but a fixed-rate mortgage allows homeowners to maintain the same payment each month, and over time, the value of their property is likely to appreciate.
In terms of safe haven assets that hedge against inflation, utilising FX during times of geopolitical instability may also help reduce risk, volatility and diversify a client’s portfolio. The same can be said for precious metals because these rare commodities tend to maintain their value. Gold, in particular, is always in high demand, and it has a high level of liquidity compared to other classes of assets like stocks and shares.
When gold is paired with a strong currency that has a high interest rate, investors and forex traders are likely to yield a better ROI because together, these assets are better protected from price fluctuations, are more likely to appreciate, and should be relatively easy to sell when the economy becomes more stable.
While some investments benefit from high inflation and can stabilise an investor’s annual earnings, IFAs can help their clients anticipate the impact on their portfolios and returns by examining data from previous periods of increased inflation. By reflecting on this information and using it as a basis to determine potential future risks, IFAs can better educate their clients on their choices and the long-term impact of inflation on their investment options.