Impact of Inflation
The recent rise in Inflation has impacted us all - whether it's an increase in the price of groceries or the cost of filling our cars with gas, inflation has affected us all in one way or another. In April 2022, the Consumer Price Index – commonly called "CPI," which measures price increases of various goods and services – was up 6.8%. This measure has grabbed the attention of media outlets as this is the largest increase Canadians have seen since 1991. Many Canadians (particularly the younger demographic) have not experienced Inflation to this extent. So, why is Inflation so important to us as consumers? It has a direct impact on our wallets and our investment portfolio return.
Understanding the Data
A good starting point to our conversation is understanding the inflation data presented in the media because, typically, the CPI figure does not tell the whole story. It is essential to know that Inflation is calculated based on last year's price of that good or service and that the price difference is quoted as a percentage. Now, you can imagine that if the price of a good last year is either overstated or understated, the inflation number seen today would be impacted. As an example – early in the global pandemic, the price of many goods and services were well below their regular price. This is simply because some services were not available due to the lockdowns. Now that prices have normalized, the current inflation number may appear higher than it actually is (relative to the "normal" price). Of course, we are not saying that is the case with the current price increases we see, as we can all agree the price we pay at the gas pump has gone up significantly! However, not all goods and services have seen the same price increase. For those on a pasta diet, we would have noticed a 19.6% increase year-over-year from April 2021 to 2022. Compare that to fresh vegetables that only increased by 8.2%. Again, when we see the CPI figure quoted in the media (6.8%), it is worth digging deeper to understand better what goods and services are moving inflation numbers and what impact we will see on our day-to-day spending.
Is Inflation affecting my Investment Portfolio?
The question is, what is the impact of rising prices on our investment portfolio? Inflation can be both positive and negative for certain asset classes. For starters, it has a negative impact on cash. All else being equal, the value of our money is worth less if the value of the goods and services we buy increases, especially pasta. Other asset classes, such as stocks, may also experience a negative impact. However, not all companies and sectors are impacted by inflation equally. Utility companies, for example, have the flexibility to increase their prices to match rising costs. Other companies that cannot pass through rising costs to the end consumer will end up facing lower profit margins. What's more, the value paid for a company or a stock can be simplified by looking at how investors approach valuation: The price paid for a business today is based on that company's future earnings. We then discount those future earnings to today's dollars. As interest rates go up, the present value of those future earnings goes down (since a higher discount rate is used), hence the lower stock price. This has had a greater impact on growth-oriented companies with higher future earnings potential, typically including sectors like technology.
What can I do?
So, what can be done in your investment portfolio to manage inflation? Inflation typically brings about heightened volatility in the markets. It is crucial to stay disciplined to your investment strategy during these market conditions. Although no one likes to see the wild "ups and downs" in the markets, it is important to resist emotional reactions (easier said than done). Working with a Wealth Counsellor can help you to assess if your investment strategy is still appropriate for your goals and aligns with your risk tolerance. The next step to managing inflation in your portfolio is to properly diversify. The goal of diversification is to protect your portfolio when a particular asset class is not performing well. In particular, assets outside of the public markets (stocks and bonds) can provide an inflation hedge – real assets such as infrastructure, agriculture, and even real estate can provide positive investment returns during an inflationary environment. It is crucial for investors to broaden their investment holdings to achieve proper diversification. The challenge is accessing these types of investments outside the public markets. If you are interested in learning how these asset classes can help navigate your portfolio through an inflationary market, please reach out to one of our Wealth Counsellors.