How To Invest Keeping Inflation In Mind

Inflation is perhaps one of the most known words in economics simply because of the widespread ramifications that it can have at a macro as well as at a household level. Simply put, inflation measures the general increase in the price of goods and services, over a specific period.

At a macro level, it has significant bearing on the monetary policy and interest rates which in turn influence capital investment and productive capacity in an economy. Case in point being the current chatter around reversing the prevailing low interest rate regime and raising interest rates.

While a rise in rates can potentially mitigate the impact of rising inflation, central banks also cannot put at risk the tepid recovery that is currently underway. At a household level, inflation directly has an impact on the purchasing power of your money and can influence your saving, investment, and spending journeys.

Inflation and Its Relationship With Your Investment Portfolio

Intuitively you would understand that if inflation alludes to a general increase in prices, fixed income bearing securities might not be an optimal investment option since the returns will not be able to make up for the rise in general prices. Further, the price of fixed income securities is inversely related with interest rates. When interest rates rise, prices fall and vice-versa.

One of the tools used by central banks to combat inflation is interest rates. Thus, in an inflationary environment, interest rates are likely to eventually rise, thereby negatively impacting fixed-income securities.

The impact of inflation on equity investments is less definite. Transient inflation may have little to no effect on equity prices and might even have a positive impact on companies that sell products with inelastic demand. However, persistently high inflation will have a two-fold impact on companies.

On the one side it will impact consumer sentiment and deflate demand and on the other side it will increase the cost of capital due to rising interest rates, thereby dampening equity prices. All physical, real assets would potentially gain from inflation since their prices define the underlying inflation.

At a macro level of global and domestic markets, inflation is one of the risk factors which impacts economic cycles and can disrupt countries if not economies in addition to wealth. Thus,

• In tough times when demand is low, governments tend to reduce interest rates / pump in liquidity boosting measures and production, causing all round growth and asset price increases.
• This in turn kicks in inflation, causing too much money to chase too few goods, forcing economic control by increasing interest rates.
• If not managed properly it can lead to either hyper-inflation or an economic recession which can disrupt a country or even the world.

Where Should You Invest To Combat High Inflation

Here are some of the investment avenues to consider making your investment portfolio inflation proof:

• Equities

Equity investments are considered as an optimal way to hedge your portfolio against inflation. Long-term index returns for Nifty and Sensex are in the 12%  to 15% compound annual growth rate (CAGR) range, which is considerably higher than India’s long-term average CPI inflation of approximately 5% to 6%. This translates to 6% to 9% real returns on investments in the long term.

Within equities, investment in value stocks could be ideal as these companies generally have better pricing power or inelastic demand which enables them to align the prices of their goods and services with inflation in a better way than companies in other sectors.

• Real estate 

The sector has traditionally proved to be a good hedge against inflation as property prices tend to witness price increases over the long-term. Real estate investment trusts or REITs are an easy way for you to gain access to real estate investments without having to shell out a fortune to buy them.

Also, REITs often pay interest and dividends as regular distributions. With dividends not being taxed (REITs in India), the overall net of tax payout to the investor tends to be superior from such investments.

• High yield bonds with short – medium duration

This is a good option to ensure that your investments earn a positive real return (adjusted for inflation).

In India, high yields generally range between 8% to 10% in the mutual fund space while options in venture debt or venture debt funds or real estate debt funds, etc., can offer yields upwards of 12% and can go as high as 19% to 20%.

• International investments

An increase in inflation not only erodes the absolute value of a currency, but also its value vis-à-vis other currencies. International investments, especially in U.S. or euro-denominated assets can help you diversify your investment portfolio and also provide a hedge against currency depreciation.

A 20% to 25% allocation to such assets which are outside of INR assets offer a good counter-inflation strategy in the portfolio in the long run (this might not necessarily play out in the shorter-term where there is inflation across global economies).

• Commodities

Historically, gold has proved to be an excellent hedge against inflation due to which most portfolios are advised to allocate 5% to 10% to gold investments. However, more recently, gold has been witnessing a higher degree of volatility and as such may no longer prove to be such a great hedge.

However, you can consider making a small allocation towards gold either through exchange traded funds (ETFs) or sovereign gold bonds (annual coupon + capital gains).

Bottom Line

To hedge your investments against inflation, the critical aspect is to look for investment opportunities that are undervalued through value stocks or markets that are relatively reasonable in their valuations apart from real assets like gold which have acted as traditional hedge.

The key, however, hinges on how economic policies navigate the interest rate and the demand maze that helps strike the right balance between controlling inflation yet protecting economic growth.