Inflation is the general rise in the prices of goods and services over time. Think back to when you were a kid; how much did an ice cream cone cost back then vs. how much does an ice cream cone cost today? Inflation applies to all goods and services in an economy. You could do the same exercise with gasoline prices, housing prices, food, and labour.
Inflation should concern investors because it slowly erodes your future purchasing power of goods and services. Going back to our ice cream cone example, if an ice cream cone costs $1 today, in 20+ years, ice cream cones may cost $2 each or more. Your purchasing power has been cut in half; therefore, you can only afford to buy half as many ice cream cones in the future. Inflation is a critical component of financial planning as we want to make the most accurate predictions of what a good life for you will look like. From a retirement planning perspective, you want to know how many golf outings or vacations you can afford during retirement.
Put simply, the money you save today will one day be worth much less. To help illustrate this point, let me give you an example. If you purchase a 1-year GIC and lock in a rate of 5% and inflation is at 6%, throughout the life of your GIC investment, you are effectively locking in a decrease in your future purchasing power. If everything had become more expensive by 6%, your 5% increase did not keep up with inflation, and from a consumer perspective, you are slightly less wealthy than when you started, despite earning 5% on your GIC. This is the investor's “real return” of -1%.
This is what makes inflation so destructive to investors’ portfolios. You can think of inflation as an undisclosed tax on society. It’s silently creating a world of lesser wealth, which will have both a negative and disproportionate impact on those who are less fortunate.
Inflation can make itself manifest in an economy through a variety of factors. One factor is natural supply and demand economics. If production costs increase, such as materials or wages, companies will pass these costs to the end consumer by driving up prices. The reverse is also true. If a product is in higher demand with less supply, consumers willing to purchase high-demand products are often willing to do so at a premium. Thus, price increases can occur naturally in an economy without any outside interference.
Inflation can also be caused by expansionary fiscal and loose monetary policies that governments and central banks put in place. To keep things simple, an expansionary fiscal policy is when governments decide to cut taxes or increase government spending. This is the government stepping in to stimulate the economy, whether by reducing taxes - meaning consumers have more disposable money to spend in the economy - or by funding programs for the betterment of society.
A recent example of fiscal stimulus the Canadian Government implemented during the COVID-19 pandemic was to offer the Canada Emergency Response Benefit (CERB). CERB paychecks were offered to Canadians who were negatively affected by COVID-19 to keep our Canadian consumer economy running effectively throughout the pandemic.
A country’s central bank controls the monetary policy, but a country’s central bank also controls the country’s money supply. In simple terms, a loose monetary policy refers to central banks increasing the money supply in an economy. Central banks can instantly create more money by printing more dollar bills or purchasing bonds. This sounds great until you realize that too much money supply in the economy is a bad thing. Too many dollars are now available to purchase too few goods, which leads to the currency’s value depreciating.
There are a lot of interesting financial products out there specifically designed to hedge (protect) against inflation. But these tend to be product specific, so I will focus on general strategies investors can implement to safeguard their hard-earned dollars.
By investing in growth assets, investors expose themselves to increased price risk in the short term. However, if you have a long-term investment time horizon investing in growth assets, such as public/private equity, the higher returns should outpace inflation better than more conservative assets. This requires a longer investment horizon and a higher degree of risk tolerance to withstand the short-term volatility in asset prices. The Kinsted Strategic Growth pool invests in these types of growth assets that are able to outpace inflation.
Owning tangible assets such as real estate, land, and commodities tend to be good hedges against inflation due to their scarcity. However, owning these types of asset classes can be challenging for most investors, and that is why we designed the Kinsted Real Asset pool to incorporate several of these inflation-hedging asset classes inside the pool.
When an economy is experiencing higher inflation than expected, central banks will intervene by adjusting the overnight lending rate upward. By increasing the prevailing interest rate, the central bank attempts to cool down an overheated economy by making the borrowing money process less appealing at these new interest rates. Investors who are investing in variable-rate assets will benefit from the increase in the rate of interest earned. Inside the Kinsted Strategic Income Pool, many of our interest-bearing investments are floating rates with an additional spread, making the pool an excellent way to hedge inflation.
At Kinsted Wealth, we endeavor to safeguard our clients’ assets and protect their future purchasing power by diversifying our clients’ portfolios across different asset classes. In so doing, we can protect portfolios from the adverse effects of inflation and ensure that we meet our client’s financial goals with non-traditional investment portfolios.