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Beating Inflation - Everything You Need To Know In 2023
What is Inflation?
Inflation is a term used in economics to signify the general rise in prices. Inflation raises prices, reducing the purchasing power of money, could reduce wealth (including real value savings), and can lower living standards. Hyperinflation (unmanageable increases in prices) has destroyed several countries – Zimbabwe and Venezuela are two recent examples. Venezuela had an inflation rate of 65,000%. In Zimbabwe, prices doubled every day.
To make things worse, we pay an indirect tax on inflation. Taxable profits are impacted by inflation – there is no tax allowance for inflation. A company’s profit of R 11 million may include R1 million due to an inflation rate of 10%. This additional R1 million will also be taxed in South Africa at 27%, therefore an additional tax of R 270,000 will be payable. Academics call this an inflation tax. Nobel prize laureate in Economic Sciences, Milton Friedman once remarked: “Inflation is taxation without legislation.”
Elon Musk was more outspoken: “Inflation is the most regressive tax of all, yet it is advocated by those who proclaim to be progressive.”
Main Drivers for Inflation
Prices rise when there is a higher demand for products/services than there is supply. This can be because there are fewer resources (available at a higher price) for suppliers to create products or services or simply because a product or service is in high demand. Below we will look at supply-side factors that contribute to high inflation.
– Energy Costs (Electricity & Fuel)
Households spend a certain percentage of their income to buy fuel and energy to stay warm in the winter, cook, and do other daily activities including travel. In respect of travelling, fuel inflation can impact individuals, farms, and other businesses. Distribution and transport cost increases, affect every stakeholder in the supply chain, thereby increasing the cost of products such as food in our local grocery store.
– Manufacturing Costs
During the Covid-19 pandemic, there were lockdowns in most countries in 2020. Factories were shut down for extended periods at a time. This meant that there was a snowball effect when it came to products not being manufactured at the same speed as before. One product that comes to mind is the semiconductor chips that couldn’t be added to automobiles, computers, and other household appliances. The prices of graphic cards for example skyrocketed during that time. This is an excellent example of how limitations in supply can increase manufacturing costs.
– Food Prices
Food as an expense in consumers’ budgets is a necessary cost. Unlike clothing or entertainment, buying food can’t be delayed and to save costs households only have the option to choose more basic food items or buy smaller quantities. Food manufacturing prices generally increase when there is either a scarcity in a main ingredient for example wheat during the Ukraine war, or when operating costs rise.
How Does Inflation Affect Your Investments?
– Cash Depreciates
Inflation can be seen as the rate at which your money depreciates. Much like you would think of a car. When you buy a new car, with each year the car ages, the value of the car would go down. Let us say the car costs R200 000 and loses 5% of its value after a year, at which time you sell the car, you will be able to replace it with a new car valued at R190 000, no longer R200 000.
A similar situation applies to cash. If inflation increases by 5% year on year, it means that your R200 000 can buy 5% less in items than it could a year ago. This is why when you are saving, you want to ensure that your savings/investment vehicle’s interest rate is high enough to largely mitigate the rate of inflation.
– Investing in the Long Term
Over time inflation can have a substantial negative impact on your wealth. You may have saved R2 million, but R2 million will not buy as much today, as it could ten years ago.
It is therefore important to protect your wealth against inflation and ensure that over the long term, your investment values increase at a rate that is higher than the inflation rate.
– Interest Rates
The Federal Reserve in the USA, and central banks in other countries (including South Africa) use interest rates to combat inflation.
When interest rates increase, individuals and companies need to pay more interest on their debt (loans, etc.) and therefore have less money to invest and spend on other items and services. This lower demand for goods and services reduces prices – therefore assists in controlling inflation.
Governments try to strike the balance where an interest rate is high enough so that inflation doesn’t spiral out of control but low enough so that people can still pay off their s and have money to put back into the economy.
Here’s Why Investment Managers Continuously Monitor Inflation
Stocks (shares) do not perform uniformly during times of rising inflation – performance differs widely. Investors can estimate a stock’s likely performance by looking at the trend of the stock’s historical data during times of high inflation.
There are multiple strategies to consider when investing during inflationary times. One strategy is to ensure that some of the assets in an investment portfolio are more resilient to the impact of inflation. These strategies are required to mitigate against risks of lower real returns on your investments. To determine the real rate of your investment in shares, you need to subtract the inflation rate from the annual return earned.
6 Ways to Invest and Beat Inflation
1. Companies with Low Debt
Investors should avoid companies with too much debt on their balance sheets. This would make sense especially when you consider that when inflation picks up, interest rates usually rise – this is how the Federal Reserve manages inflation.
This means that there will be higher interest costs for companies if they have a lot of debt on their balance sheet. Higher finance cost results in lower earnings and a resulting decline in share price.
2. Companies that Transfer the Inflation Burden to Consumers
During 2022’s rapid increase in inflation, many companies have reported lower profits, due to rising operating costs. However, some products have price elasticity, meaning that despite rising prices, consumers will not buy fewer units of the product.
Medicine is a case in point – even if the price rises, you must still have your medicine. These companies are often monopolies or oligopolies in their industries.
Companies with a clear competitive advantage could fall into this category as well. Defensive sectors such as utilities, consumer staples, healthcare, and telecommunications can pass on costs to consumers and tend to perform better during times of high inflation.
By investing in companies that can retain their profit margins despite rising costs, your portfolio could be more resilient during times of inflation.
3. Inflation-Protected Securities
Inflation-protected securities such as TIPS (Treasury Inflation-Protected Securities).
TIPS are government bonds that mirror the rise and fall of inflation. So, when inflation goes up, the interest rate paid (on the bond) also goes up. And when deflation occurs, interest rates fall.
Because USA TIPS are backed by the U.S. Federal government, they are one of the safest investments and an effective way to diversify your investments while also supplementing future retirement income.
Locally an inflation-linked bond ETF that tracks the performance of the S&P South Africa Sovereign Inflation-linked Bond 1+ Year Index can be used. The bond’s principal in the fund is indexed to the local inflation rate. As such, the security typically guarantees a return above inflation if held to maturity.
4. Invest in Real Estate or Real Estate Investment Trusts (REIT)
Real estate investing is also considered a hedge against inflation, as the asset class generally has little correlation with most stocks and bonds.
You can invest directly in real estate or invest real estate companies that are listed on the stock exchange, most real estate companies listed on stock exchanges are Real Estate Investment Trusts (REIT).
Real estate investment diversification could include investing in different types of real estate such as homes, apartments, office- and retail properties. Another important element is to consider locations across the globe.
When considering cash to combat inflation, you can invest the cash in a different currency.
Currencies fluctuate daily, depending on global events, however, the idea is to invest in a currency that will strengthen in relation to other currencies over time.
6. Commodities like Precious Metals, Energy & Agriculture
You can also consider commodities or invest in companies involved in commodity industries to hedge against inflation. Commodities include precious metals (gold, silver, platinum, copper), energy, livestock, and agriculture.
We explain below what the precious metals and energy benefits are, in relation to investments.
Precious metals are difficult to mine and therefore there is a limited supply of precious metals. When the demand is high for precious metals, the prices will rise, even during times of inflation.
Investing in gold has been a diversification strategy for many investors throughout history. To invest directly or indirectly in gold, you could buy physical gold, (for example gold coins), gold exchange-traded funds, or shares of a gold mining company.
A 2021 research paper by SSRN, “The Best Strategies for Inflationary Times” found that across all sectors only energy stocks showed positive annualised real returns during a period where the U.S. inflation was 5% or higher.
Energy-linked companies that focus on the exploration and production of oil, gas, and renewable energy sources were the optimal stocks to hedge against inflation, according to the report.
To learn more about energy as a commodity investment, including Brent crude oil, you can read our South African report on “Investing in times of inflation”, written on 28 June 2022.
Where do I Get Help when Investing?
When considering an investment in shares or other assets, it is best practice to consider the past performance, current financial situation, and future prospects of the investment.
This process can be complex and unless you have the necessary skills and experience it would be best to leave this process to the experts. An experienced investor is not caught off-guard by inflation.
Sound investors consider the landscape and ensure their investment strategy is developed to build wealth during times of inflation. As we mentioned, to safeguard your investments from inflation you should choose your investments wisely.
Our Wealth Managers can guide you through your current investment portfolio, and propose ways to restructure it, where needed, with the aim of improving your investment during periods of high inflation.
Contact us to see if your long-term strategy is still the right strategy for today’s economic environment.
Spend some time with our team to find out which one of our portfolios is best for you.