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