Our friend asks us, how serious is the threat of inflation?
Inflation is an economic phenomenon where the prices of a large sample of goods and services increase steadily over a period[1]. There are several causes, the most common being a lasting imbalance between supply and demand, or a significant increase in the quantity of money.
As examples, the disruption during the COVID 19 pandemic caused a temporary drop in the supply of a wide catalog of products, causing price increases for several months.
On the other hand, the increase in the monetary base, resulting from central bank’s intervention in public financing[2], causes an increase in the nominal value of purchasing power, which in turn causes an increase in the prices of a limited supply of goods and services.
The main effect of inflation is the loss of purchasing power or value of the currency, encouraging its timely conversion into real or foreign assets. In this sense, an inflationary outbreak can cause an accelerated outflow of capital and with it a devaluation of the currency[3].
Another effect of inflation is the loss of value of debt previously issued and with fixed coupons. This is because these coupons will cease to be attractive as they do not compensate for the loss of purchasing power of the invested capital[4]. Nominal yields will tend to rise as investors expect the increase in the inflationary component to be compensated.
Uncontrolled inflation can cause companies to have worse financial results[5], since the sales price should be enough to cover the future cost of replacing inventories. Persistent and significant inflation can lead to a reduction in sales volumes (units).
The worst type of inflation[6] is the one where all economic actors begin to make decisions in the expectation that inflation will be persistent. In these cases, the increase in prices, costs and revenues becomes chronic, entering a cycle where inflation reinforces itself.
Inflation negatively impacts a wide spectrum of society, both people and companies and institutions. Therefore, serious and independent central banks have it in their mission to keep it under control at low and predictable levels.
For the investing public, the main concern should be to predict whether an inflationary outbreak will be mild or severe and whether its duration will be short or long term. Mild and short outbreaks often cause temporary adjustments in the value of some financial assets. Long and severe outbreaks, on the other hand, often have a significant negative impact on the value of assets such as debt securities[7] and, by increasing the yield obtainable in one asset class, can lead to falls in the value of other assets[8].
The recommendation to protect wealth in the face of moderately high inflation is usually a preference for real assets, shares of high-quality companies, foreign assets in hard currencies, and safe haven assets such as precious metals. Assets protected from inflation such as shares of some public infrastructure companies and inflation-indexed bonds should be added to this list. As for cryptocurrencies, and in our opinion, their expected reaction to high inflation periods has not been sufficiently established.
A particularly severe combination is stagflation, an even rarer economic phenomenon where high inflation and slowing or declining economic activity are combined.
We tell our friend that inflation is serious and the best thing to do is to avoid it. Once in front of it, all that remains is adapting to reduce the loss of value.
Notice: The information provided herein is for educational purposes only. Portfolio Resources Group does not guarantee the accuracy of any tax recommendation, as we do not provide tax or legal advice. Consult a tax professional to ensure that the recommendations are appropriate for your particular situation.
[1] A price increase that is not persistent or that only affects a small group of items is not considered inflation.
[2] See extreme cases of Weimar Germany, Zimbabwe or Venezuela.
[3] See also the cases of Argentina and Turkey.
[4] The nominal rate of return used as a baseline, excluding credit risk, typically includes a real return component and a projected inflation component. If actual inflation is higher than projected inflation, real yields may erode entirely.
[5] In the short term, and depending on the company’s market leadership position, they may be able to offset cost increases by adjusting sales prices. However, this has its limits.
[6] aka “entrenched inflation”.
[7] Particularly severe on those with longer terms to maturity.
[8] It should be remembered that the valuation of all assets is related, since the expected return of one asset is usually relative to that which would be obtained in another asset. The change in one asset causes a reaction in the others.