Are you saving for retirement? For your children’s education? For any other long-term goal? If so, you’ll want to know how inflation can impact your finances. Inflation is the general increase in prices and fall of the purchasing value of money. Inflation rates have fluctuated over the years, and these fluctuations are normal. As a result, short-term changes are acceptable. The real issue is the effect of long-term inflation. Over the long term, inflation erodes your income and wealth purchasing power. This means that even as you save and invest, your accumulated wealth buys less and less over time.
Over the past few decades and during most investors’ lifetimes, inflation has not been a significant factor in markets. There have been strong disinflationary forces. Monetary policy was the driving force behind this, and impacts have flowed increasingly quickly to portfolios. With inflation not being a significant factor, the Federal Reserve and other central banks worldwide over the past decades have continued to step in and resolve the problem very quickly. Now the problem is, the world we are living in may be very different. While there is continued discussion around geopolitical tensions, the need to decarbonize and address climate change, and rising social pressures, there has yet to be quite an internalization that all of those things require inflationary spending.
A lot needs to be spent to address the geopolitical tensions and the climate change story, and you’re in this environment where, coming out of COVID, a new method has been learned, which is that you don’t have to use monetary policy. That will be a tough lesson to forget about and is naturally more inflationary because you’re spending to resolve your issues, whether they’re a downturn, social problems, or environmental problems we need to deal with.
The bottom line is that this is not a 2% inflation world. That will not happen magically if we want to get back down to 2%. It will take either much more economic weakness than we’ve already seen or significantly more tightening to bring it down.
The effects of inflation can’t be denied — yet there are ways to fight them. It would be wise to own at least some investments whose potential return exceeds the inflation rate. A portfolio that earns 2% when inflation is 3% loses purchasing power each year. There are different avenues to construct portfolios that are inflation resilient. Typically, these focus on real assets that can pass off price increases to consumers. Some of these assets include commodities, real estate, timber, and infrastructure. These alternative asset classes are not right for everyone, as these investments are less liquid than traditional assets.
Diversifying your portfolio — spending your assets across various investments that may respond differently to market conditions — is one way to help manage inflation risk. Diversification has gotten a lot more challenging, which is part of why thinking about where you’re getting your alpha, what you’re being paid for liquidity premium, and where alpha is available is so important. So without as many opportunities for diversification, any chance you have for diversification must be taken advantage of much more significantly. You have to be a lot more serious about thinking; what do I have that protects me against inflation? What do I have that gives me any geographic diversification? and lean into that because you know that opportunities are just less than before. If you would like to know more about possible strategies to protect your portfolio against inflation, book a meeting with one of our advisors today!