How does inflation affect investment activity?
Where does inflation come from?
It is traditionally believed that the flywheel of inflation begins with the growth of wages in the country and therefore the money supply. The process of inflation dynamics can be shown in the form of the following stages, traditionally called the “inflationary spiral”:
Inflation and investments
Inflation can lead to both positive and negative consequences in investment activity.
Let's start with the positives:
- Higher profits for companies
Increased demand for goods and services indicates that consumers are willing to pay more. As a consequence, this will lead to an increase in share prices, which will benefit investors in the form of returns on their portfolios. Raw materials are a typical example. Commodities and inflation have a unique relationship – commodities are an indicator of future inflation. As the price of a commodity rises, so does the price of the products for which it is used.
- Increasing profitability of fixed income instruments
To adjust for inflation, central banks raise interest rates, which raises the rates of fixed income financial instruments. Such events allow traditional and conservative investors to benefit to a large extent, using, for example, bank deposits or bonds.
- Portfolio diversification
Inflation may encourage investors to rethink their portfolios by adding stocks, bonds, and commodities to a range of assets, as they are less affected by inflation.
However, the positive features are counterbalanced by the painful negative aspects of inflation:
- Decreased purchasing power of investors
Investors' assets at the time of inflation are worth less due to rising prices in the economy. It
can also lead to a decrease in the real standard of living.
- Rising prices for business
Inflation drives up interest rates, which can make it more costly for businesses to borrow and invest in growth and expansion. This may negatively affect the overall growth of the economy in the long run, putting it into recession. For investors, this means decreased attractiveness of companies with a large borrowing ratio.
- Decreased consumer spending
With inflation, consumers have less money to spend due to rising prices. This can lead to a
decrease in company profits and, as a result, a fall in share prices in the value approach to
investment valuation.
- Uncertainty for investors
Inflation leads to a decrease in investor confidence, which shows lower demand and falling share prices. If the uncertainty of investors' expectations grows, then most likely they will either sell their assets for a certain period of time, “cashing out”, or look for assets that are not dependent on inflation.
The effect of inflation on investment is a double-edged sword. On the one hand, it stimulates economic activity in the short term. On the other hand, there are also negative aspects, which, if ignored for a long time, in the long run can lead to the downturn of not only the national, but also the world economy.
For investors, inflation rate is the minimum acceptable return for their investment strategy. In order not to lose in profitability, during a period of high inflation, they try to shift their money into assets with low risk and high fixed income. In a period of low inflation, on the contrary, they withdraw money from conservative instruments and allow themselves to take risks to obtain high returns.
