Introduction:
What are asset classes and how these assets behave in the time of inflation is a tricky question. We have seen a difficult time after corona when respective financial authorities started raising interest rates in their countries e.g. USA, England and Germany to name a few. The interest rates increase is usually to curb the economy running hot. To control the gross domestic product (GDP) it is usually necessary to take money from the investors in the market to regulate the flow of money in the market. Today, the discussion would be about different asset classes but from the perspective of effects of inflation on these assets.
Focus Points
- Interest Rate Increases Post-Corona: Financial authorities in countries like the USA, England, and Germany raised interest rates to control GDP and regulate money flow.
- Stocks and Inflation: The relationship between common stocks and inflation is non-linear and unpredictable, affecting consumer spending and company revenues variably across different periods.
- Bonds as Safe Investments: Bonds, including I-bonds and treasury bills, are less volatile than stocks and offer protection against inflation, making them stable options for investment portfolios.
- Real Estate and Inflation: Higher inflation impacts real estate through increased interest rates and higher costs for owners and tenants, often slowing down market investments during inflationary periods.
- Commodities as Inflation Hedge: Commodities like gold, oil, and wheat are highly volatile but can serve as a hedge against inflation due to their sensitivity to demand and supply cycles and natural events.
Stocks: A Simplistic View
When we buy a Pizza, we usually slice it to share it with friends, family or the people we know. Companies also do the same, when they grow or they want to grow, they need money to invest in different projects for the future of the company. They slice the company’s worth into small pieces and share it with the general public. These shares represent the ownership in that company. Anyone buying a piece is entitled to profit or loss that the company bears. If the company performs well the price of the share goes up and vice versa.
Stocks: Is there an answer
The connection between common stocks and inflation is not a linear connection. The data of the past has shown that there is no clear pattern between the two. Usually, when the GDP increases the inflation increases too. Increased inflation beyond an acceptable level of 2-3% means increased prices of consumer products e.g. food and clothing. This can effect the consumer spending and that in turn effects the profits of companies. Less consumer spending means less product/service buying from the companies that reduces the companys’ revenue. The decrease in company revenue also hurts the stock prices and that effects the portfolio of the investor.
If we look at the data of the past, during the five year period of 1966-1970, the cost of living was risen to 22% (High Inflation Period) but the stock earnings and the stock prices declined since 1965 (The Intelligent Investor). Other periods show an increase in the stock prices and earnings during inflationary period, so it is difficult to predict the effect of inflation on the stock prices. The only predictable thing is that inflation is here to stay even in the future.
Bonds: What are they
The debt issued by governments, organizations and corporations around the world are called bonds. When an investor buys a bond, the investor usually lends the money to the entity. The entity is bound to pay interest to the investor on the money taken by the corporation or government, upon the maturity of the bond the original (Base) investment/ money will be returned to the investor. The different types of bonds include I-bonds, treasury bills and corporate bonds. The I-bonds (Inflation bonds) provide protection against inflation and usually consists of two parts: A fixed part that gives a consistent interest rate for the life of the bond and a variable part that changes with the change in the inflation. The variable part is calculated and announced twice yearly (Bogleheads).
Bonds: Are they really good
Bonds are not correlated to stocks. Bonds do not follow the trend of stocks. Bonds provide investors with the diversification opportunity and stability in their portfolios. Due to the less volatile nature they are consistent in the time of crashes or market dips unlike stocks. The treasury bills and I-bonds are dependent on the inflation environment. The values of these bonds are set after looking at the inflation values. For the short period of time (<=2 years) the treasury bills are preferable while for longer period and unpredictable inflation the I-Bonds are preferable. In short bonds have always shown resilience against inflation and are a safer and stable option for an investment portfolio.
Real Estate: Bricks And Mortar
It is not just a combination of bricks and mortar instead it is a construction science that takes years of planning and resources. There are different types of real estates: Residential Real Estate, Commercial Real Estate and Industrial Real Estate. All these categories serve different purpose. Residential real estate serves the purpose of building homes, colonies or residential complexes. Commercial real estate (Investopedia) is for the shopping malls, gas stations, grocery stores and even rented apartment complexes. Industrial real estate is used for manufacturing purposes where productions lines are operated e.g. Tesla, VW, BMW, Kraft Heinz and many other conglomerates.
Real Estate: Real Protection From Inflation?
When inflation rises above acceptable levels of 2-3%, it effects almost every aspect of human life. From groceries to medicine, everything’s becomes expensive. Some things can’t be avoided as food and medicine are a mandatory part of human life. Housing is also a mandatory aspect of life but it also gets effected during inflationary times. As inflation goes up, the interest rates on properties also go up. The higher rates are passed on to owners if it’s a single family home. In case of tenants the interest rate hike is also passed on to the tenants in terms of higher rent. So, the inflation also slows down the real estate market. People tend to not invest in real estates when the inflation is higher.
Commodities: Feel them in your hands
The input or the combination of the inputs that is required for the production of a finished good is a typical example of commodities. Commodities are gold, silver, copper, wheat, corn, oil, natural gas and many other nature based products. Copper is used in the construction and production of semi-conductors while wheat is used in the production of all the breads or wheat related products around the world. Coffee beans are used as the input by every coffee manufacturer for the production line of different tastes and strengths of coffees.
Commodities: Hedge Against Inflation?
All the commodities are mostly affected by the demand and supply cycles. The commodity business is highly volatile because any environmental catastrophe or disaster like floods, storms, earthquakes etc. can reign havoc on the prices of any commodity. An example would be, if a major oil producer like Saudi Arabia is hit by any calamity then the supply from Saudi Arabia will decrease and that will cause a panic in the oil market, that in turn will increase the amount of oil per barrel and the investors will benefit from this surge in prices. Commodities can be a good hedge against inflation because the raw material prices goes up, hence the commodity price goes up. Diversification can be achieved because the stock markets can not effect the prices of commodities and there is no pattern between commodities and real estate or stocks.
Conclusion:
In conclusion, navigating the complex interplay between inflation and various asset classes is no easy task. As we’ve seen, stocks, bonds, real estate, and commodities each respond differently to inflationary pressures. Stocks offer potential growth but come with volatility tied to consumer spending and company performance. Bonds provide a safer, more stable investment, particularly in the short term with options like Treasury bills, or longer-term with I-bonds that adjust for inflation. Real estate, while a necessity, faces its own set of challenges under high inflation, influencing both property values and rental rates. Commodities, on the other hand, serve as a potential hedge against inflation but are susceptible to supply and demand shocks.
Understanding these nuances helps investors make informed choices to balance their portfolios and mitigate risks. While inflation remains a constant factor in the economy, a diversified approach, leveraging the unique strengths of each asset class, can offer a measure of protection and stability. It’s a dynamic journey, one that requires vigilance, adaptability, and a keen understanding of market dynamics to navigate successfully. If you would like to know about prudent spending habits, check this out!
