During inflationary times investing can be frustrating as the measuring stick (U.S. dollar) used to determine the value of future returns keeps getting smaller. With inflation comes the antidote of higher interest rates. Inflation and higher interest rates don’t automatically spell doom for investors, but some changes to retirement portfolios and the way investments are made should be in order.
Valuations Are Thrown Out the Window: The value of assets can be established in more than one way, but most valuations consider the present value of future returns or earnings. This discounted value can be seriously eroded by runaway inflation, and the higher interest rates it takes to get rid of it. If the inflation rate is 1%, the value of $100 ten years from now would be about $91today. But if the inflation rate rises to 5%, the value of that same $100 would be about $61 today. When discounting an investment’s future earnings, the analyst does not have a crystal ball and cannot determine straight away what inflation will be like five to ten years from now. Therefore, the mix of the investment options that are available gets swizzled by present values that are hard to establish since the criteria is rapidly changing.
Inflation Doesn’t Impact Every Investment the Same Way: We know that inflation is best handled with higher interest rates (monetary policy), and cutbacks in government spending (fiscal policy). Investments that are more sensitive to interest rate increases, such as bonds and other fixed assets, could face serious valuation declines as rates rise and bond investors go for the newer, higher paying issues. Risky assets, such as biotech startups that won’t have substantial cash flows in the near term, are less likely to draw in long term investors. Private equity relies on influxes of long term capital that is turned around and invested in declining corporations that need capital infusions as well as operational reorganization. But when interest rates for US Treasury bonds rise to 4.5%, should investors shed those safe returns for the risk of 7% return with Private Equity?
What Sectors Are the Best to Follow Right Now: Of the nine sectors that I currently have investments in, only three are in the black at the moment. One is Energy, which is highly volatile. The others are Materials and Real Estate. Most commodities have opportunities to hedge against inflation with futures markets that are deep and liquid. This enables investors to trade positions in the sector without having to manage the actual commodity itself. The rent and usage fee revenues from the Real Estate sector have a tendency to rise during inflation. In the above sectors, many investments pay good dividends that don’t necessarily get impacted by inflation. There’s always the risk of recession cropping up as the effort to fight inflation can suppress growth, but this risk affects just about every sector albeit in different ways.
House Valuations Could Fall Below Their Corresponding Mortgages: The one investment that many people rely upon is their home. During inflation, the rising interest rates make it harder for homeowners who need to sell their home and buy a different one. Such a trade would mean a new mortgage for the new home, and a buyer for the existing home who can afford a mortgage with a higher interest rate. The low monthly payment needed for the existing home might be replaced by a significantly higher payment for the new home. The lack of qualified buyers might force down the value of the existing home, making it harder to transfer any equity to the new one. If the home’s value falls below the amount of the mortgage, selling the house at all could be a problem.
Retirements Might be Pushed Back: Those employees that are approaching retirement age are at greater risk, as it could be costly to rebalance retirement portfolios into assets that are safer and more suitable for steady cash flow, such as bonds, annuities, and other fixed investments. These investors are more vulnerable to shocks in the marketplace as unanticipated losses often cannot be recouped—there is less time available for growth, and more amounts of money are needed to be withdrawn to cover the increased cost of living. Further, many future retirees have been advised in the recent past to convert larger portions of their portfolios into bonds in that fixed investments are generally safer. But bond valuations for existing issues face a steady hammering from runaway inflation.
What Can Be Done About it: Inflation will eventually be controlled with the Federal Government and Federal Reserve making good decisions. The tightening cycle will come to a stop, but the actual inflation rate will take a certain amount of time to be restored to its desired 2% level. The last time we had runaway inflation it lasted over 16 years. This time will surely be shorter, but as investors we should not expect an easy, early exit from it. Many of those asset values that are being hammered today will one day become bargains—the first of which will likely be bonds. New issues are released by major corporations on a regular basis, and each ensuing issue should pay a higher rate of interest than the last one. Further, the newer issues should hold their values through the inflationary period and increase in value as interest rates come back down. In the worst case scenario, those bonds bought previously should simply be held to maturity assuming the corporate entity has good fundamentals. Mainstream equities that pay dividends and have solid fundamentals should more or less hold their value over the long run as long as they continue to pay those dividends. Speculative investments should be avoided until inflation peaks, and the future of interest rates becomes clearer. If the investor can continue as a wage earner through this period, the savings, pension plans, and entitlements will all provide greater future incomes as the pension and entitlement payouts are usually greater with more years of service. Small businessmen and homeowners should, if at all possible, avoid taking on more long-term debt.
Sources: The Economist, The New Rules of Investment, December 10th, 2022.