FAQs on inflation & investing
1. What is inflation and how does it affect investors?
Inflation is the tendency of the prices of products & services to rise over a period of time. As investors make various investments based on future goals such as saving for children's education/marriage or retirement, their investments need to beat the rise in the cost of living over the long-term. When inflation is low or moderate, investors are more confident about investing for the medium to long-term while investors become wary about investment decisions in a high inflation environment.
2. How does inflation affect various asset classes?
Higher inflation has the greatest negative impact on the debt asset class. This is because while the interest rate that the investors would get by investing in bonds is fixed at the coupon/fixed rate of interest, this investment declines in value as the rate of interest on the newly issued bonds increases as the central bank's set interest rate increases to offset the rise in inflation. Gold and commodity-related investments tend to do well in a rising inflation scenario as inflation causes a decline in the value of the currency over time. Cash as an asset class tends to perform better than debt as the return for parking investments in short-term cash deposits increases with an increase in the central bank's policy interest rate. There is a mixed impact on the performance of equity due to a rise in inflation. While moderate rising inflation is good for equity as an asset class, high inflation turns out to be negative for the performance of the asset class.
3. How does inflation impact equity over the medium to long-term?
There is an uneven impact from the rise in inflation in equity. As the intrinsic value of a share is the present value of the discounted cash flows that a company will generate over the medium to long-term, inflation tends to be both positive as well as negative for the intrinsic value of the share. The future cash flows for equity holders may increase as inflation leads to the company raising prices for its products; thus, increasing revenue (assuming volume of products sold remains unchanged) and the discount rate used to value these cash flows also increases thereby, offsetting the positive benefit from higher cash flows. Higher inflation tends to negatively impact the companies with higher ‘equity duration’ i.e those companies that are likely to get their cash flows further in the future, for example, five years or more.
4. What has been the experience of investing during inflation?
While we only have a 30-year history of tracking the inflation and stock index for India, the US inflation study has more than a 50-year track record for examining what investors earned during various inflation environments. We start with the 1970s where the US experienced inflation of over 10 per cent for several years during the decade and resulted in returns that were below the rate of inflation during the time. At the beginning of the 1980s, inflation started trending lower and this set the stage for one of the longest equity bull markets in history, which ended in early 2000. While inflation was relatively well-behaved in the decade from 2000 to 2010, equity market returns managed to perform better than in the 1970s. The last decade, which experienced low inflation, has been good for equity market returns with the benchmark S&P 500 returning over 10 per cent per year over this decade.