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Over the past four years, inflation has caused a lot of anxiety in grocery stores, lumber yards, and even concert venues. As of May 2020, consumer prices were almost flat compared to the previous year. By June 2022, annual inflation Interest rates rose to 9.1% but then began to settle, resulting in overall prices in December 2023 rising 3.4% year-on-year. While this is close to the 2.9% average over the past 40 years, it is still not ideal.
Inflation can also wreak havoc on your portfolio. “Inflation affects portfolios in profound and obvious ways, and in more sneaky and sinister ways,” he says. wiley tollettchief investment officer at Franklin Templeton Investment Solutions and co-author of a 2022 study on what types of investments work best in times of inflation.
First, inflation reduces purchasing power and erodes the value of investments. And when inflation is rising, central bankers tend to respond with higher levels. Interest level This is to cool down the economy and keep a lid on prices. For example, the Fed has raised its benchmark interest rate 11 times since March 2022. Stock prices and interest rates have fallen due to the one-two punch of rising inflation and rising interest rates. bond Unsettled, 2022 was a rare year in which both markets crashed.
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More subtly, inflation rates can also affect overall market valuations, or the prices investors are willing to pay for financial assets. Generally, the higher the inflation rate, the less investors are willing to pay for stocks.
One rule of thumb is that a stock is overvalued if the average stock price is: Price earnings ratio (PER) The overall stock price is higher than 20 minus the inflation rate. Based on an expected inflation rate of approximately 3% in 2024, this means that the fair value of the S&P 500 index is approximately 17 times its expected earnings. As of January 31st, the S&P 500 index was trading at a P/E ratio of 21.7x, which is several times higher. Giant growth stocks called the “Magnificent Seven”.
Similarly, investors are generally only willing to keep their money in a bond if they believe the bond’s interest rate will outpace inflation over its life. “It’s all about inflation expectations,” he explains. Rob ArnottFounder of investment company Research Affiliates.
No matter how bad inflation is, stagflation It could even get worse (if inflation is rising but the economy is stuck in a rut) deflation (A sustained and widespread decline in prices could destabilize the entire economy). Economists say there are essentially five different types of pricing environments, or “flation,” each of which affects portfolios in different ways. Below is a list of which types of investments tend to be successful in each.
inflation
A small amount of inflation, a sustained increase in the price level of goods and services, is generally considered to be beneficial to the economy. But when prices start rising by more than about 2% a year, policymakers, bankers and businessmen become concerned.
Business owners, fearful of delayed profits, often begin raising prices, and workers demand higher prices, potentially creating a dangerous upward cycle. Investments that have historically survived high inflation include: energy stocks, directly held residential real estate (real estate investment trusts have had much less inflation protection in previous cycles), and Treasury inflation-protected securities. TIPS is the Consumer Price Index (consumer price index).
Commodity funds also tend to beat inflation. For example, the TCW-enhanced product strategy (TGABX), a member of our favorite Kiplinger 25 list. no-load investment trustthe return from March 2021 to May 2022, the most recent period of rising inflation, was 44%.
Tollett says stocks generally can be a poor inflation hedge in the short term, but can serve as strong protection for investors who want to hold on for more than five years. Fixed-income bonds typically perform poorly during periods of high inflation.
disinflation
When the rate of price growth slows, disinflation occurs, and that is what we have now. During disinflation, unlike in periods of deflation, prices still rise, but sometimes painfully. The key difference is that it’s rising more slowly than it has recently.
The good news is that modest increases in inflation, such as the economic cooling experienced in 2023, are usually a boon for investors because they bode well for corporate profitability and, by extension, stock prices. During this period, investors are often rewarded for taking more risk, such as buying shares in growth-oriented companies.
Since inflation began to decline in July 2022, the growth-oriented Nasdaq Composite Index has comfortably outperformed broader indexes such as the S&P 500, for example. Lower inflation also means that bonds purchased during periods of higher inflation now promise higher “real” returns, or inflation-adjusted returns. However, in previous periods of disinflation, commodities have performed poorly.
Noflation
Periods of stable prices (usually defined as periods in which overall consumer prices increase by less than 2% per year) are sometimes referred to as “non-flation.”Those tend to be the “golden age of financial assets,” he says. Gary SchlossbergGlobal Strategist at Wells Fargo Investment Institute.
Remember from 2013 to 2019, when the Consumer Price Index generally hovered below 2%? The S&P 500 posted significant gains in six of his seven years, producing an above-average annual return of 13.6%. Price and economic stability create a favorable environment for almost all investments, but especially for riskier investments such as growth-oriented stocks and small-cap stocks, Schlossberg said.
deflation
Prices for some items, such as computers, gasoline, and seasonal food, drop from time to time. But general economy-wide price declines, or deflation, are rare. That’s a good thing, because deflation can lead to a vicious cycle. A weak economy leads to lower wages, layoffs, and reduced spending, which in turn leads to lower prices and further weakening of the economy.
The United States has experienced general deflation only twice in the past 100 years. The period from March to October 2009 overlapped in part with the Great Depression of the early 1930s and what many would call the Great Recession. In both periods, stock prices initially fell much more than consumer prices and took years to recover. During deflation, highly volatile products also tend to suffer. Bonds that pay a positive fixed interest rate provide positive real returns unless a default occurs.
stagflation
Inflation that coincides with a downturn in the job market and economy, known as stagflation, creates truly difficult times for investors. Economic downturns mean companies are unable to raise prices enough to recover costs, shrinking profits and often causing stock returns to fail to keep up with inflation.
From 1973 to 1982, annual inflation averaged 8.7% and average unemployment exceeded 7%. However, the S&P 500’s average annual return over this period was only 6.7%, meaning investors lost purchasing power. The economy escaped fears of stagflation during the pandemic.
Tollett says if you want to avoid this kind of painful economic downturn, your best bet is TIPS. TIPS are guaranteed to return your investment and rise in line with inflation if you keep them to maturity.
Note: This item first appeared in Kiplinger’s Personal Finance Magazine, your trusted monthly source of advice and guidance.Subscribe to help us make more money and keep more of what we earn here.
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