How should investors respond to inflation?
July 3, 2021
For more than a decade, inflation has been essentially dormant. In recent months, though, economists have expected an uptick but were still surprised by the sharp jump in the April Consumer Price Index (CPI), which rose 4.2 percent from a year ago. As an investor, what can you expect if we do enter a more inflationary environment?
First, it's useful to understand the main causes of the recent spike in prices. Part of the explanation is simply a result of increased economic activity in the spring of 2021 over the same period a year ago, when prices collapsed at the height of the COVID-19 pandemic. And this reopening of the economy has also resulted in a surge in demand for travel-related services such as hotels, airfare and rental cars. Another contributing factor is a widespread shortage of manufacturing materials that have limited production and driven up prices for an array of consumer goods.
Will this inflationary pressure continue? It's not easy to make predictions of this nature, but, for now, the Federal Reserve seems to believe the recent price hikes are temporary, and, as a result, will continue its policy of keeping interest rates low. But a few more months of higher-than-expected inflation could change the Fed's view and its actions.
In any case, how should you as an individual investor respond to even the potential threat of rising prices? You'll need to keep in mind that inflation affects different types of investments differently. Consider fixed-income securities such as bonds, which pay a set interest rate – the coupon rate. Because rising inflation erodes the value of a bond's future income, bond prices typically fall during inflationary periods. This is particularly true of longer term bonds, due to the cumulative effect of the lower purchasing power. On the other hand, stocks – especially those of larger companies – tend to do well during inflationary periods, which might not be that surprising, considering that a company's revenue and earnings may increase at a rate similar to that of inflation. Of course, "stocks" is a broad term, and some industries will do better than others when inflation is on the rise.
Even if inflation keeps advancing, you may not want to make significant changes to your investments. For example, although their prices may fall, bonds can still be valuable assets, since they can help reduce the impact of market volatility on your portfolio. And if you've already got a good mix of stocks appropriate for your goals and risk tolerance, there's probably no need to shake things up.
Here's one more thought to keep in mind about inflation: It serves as a reminder that you'll always need to have a reasonable percentage of growth-oriented investments in your portfolio to avoid losing purchasing power. As we've seen, inflation won't always be in hibernation.
Ultimately, your own actions and decisions will determine your success as an investor, but you'll still want to be aware of how a development like inflation can affect the economy and the financial markets. If we are entering territory we haven't seen in a while, it pays to stay alert.
This article was written by Edward Jones for use by your local Edward Jones Financial Advisor.
Edward Jones, Member SIPC.