“Inflation” is the one dreaded word that can shake the confidence of economists, investment bankers, policy makers and even the government! Well, the harsh reality is that if the economy is growing inflation will definitely raise its head to haunt you. Let’s try to explore why it is such a dreaded word and is there any hidden opportunity for an investor to generate profit out of this?
Inflation is a state where there is steady (at times not so steady) increase in price of goods and services. If there is too much money rolling in the system it will lead to inflation as people will have more money, which makes them willing to pay more for the same amount of goods or services.
Effects of Inflation on the market
Increasing inflation affects each and every sector of economy either directly or indirectly. The best buddies of inflation are rising interest rate, crashing stock markets, unemployment, rising bond yield and of course stress, which makes it appear on everybody’s watch list.
Market Behaviour –
Inflation numbers are closely watched by analysts and investors. If there is slow and steady growth in inflation stock market behaves positively as inflation is considered a necessary evil. If the number is too high then we always see a knee jerk reaction in the negative direction.
Interest Rate cycle –
The prime reason for inflation is too much money in the system. Hence to curb it, policy makers increase interest rates so that liquidity is sucked out of the system. But as the interest rate rises, so does the cost of capital. Increasing cost of capital hampers the earning potential of companies leading to decreasing confidence of investors, resulting in stock market fall. Once the stock market falls people start running towards safer options like investment in government securities. At this point excess money seems to be resting in peace and the interest rate starts to decline and the whole cycle starts again!
Effect of inflation on investment decisions
So should you be bothered about inflation and alter your investment decisions based on it. If majority of your investment is in fixed income securities or in bank deposits then the answer is YES. Returns from fixed income securities are quite closer to inflation rates and hence you do not gain much in long run. The situation is worse if you sit on pure cash as your purchasing power is dwindling day by day.
If we cannot avoid inflation, let’s figure out how to extract the most out of it. Two options which will provide a shield against eroding nature of inflation are the following.
Investment in stock market –
Generally every good company in the long run generates earnings, which is above inflation rate. Companies have the option of increasing prices of its products to enhance earnings and this pricing power acts as a weapon to fight inflation. As a smart investor, one should look for companies which can utilise this pricing power in times of persistent inflation.
Commodity prices are quite reactive to inflation and adjustments in prices are very fast so one should not ignore companies which deal in commodities. In an inflationary environment, most of the time we witness market crashes. One should use this opportunity to enter the stock market to reap better returns in future.
Investment in real estate –
In an inflationary environment, investment in home and land is always a safer option. Generally the price of a house and land increases with time and rate of appreciation is higher, as land is a limited resource. If you already have a house of your own you could think about taking a home loan to procure a home in the outskirts and let it out for rent. This could work well in terms of a passive income as well as in investment that appreciates in future. If you are not keen on a loan and have enough excess funds you can go for an outright purchase.
Inflation Indexed Bonds –
RBI is also exploring the possibility to bring out inflation indexed bonds. The return on these bonds will be a little above the rate of inflation. When this is launched, inflation indexed bond could be a very good option for risk averse investors.
As it’s clear that we cannot avoid inflation let’s make some smart investment choices to cope with it better. An interesting aspect is that inflation at times provides you an opportunity to buy some good stocks at cheaper prices. Just remember to be vigilant and be on the look out for opportunities.