Should investors fear inflation?

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Personal Investing

25 May 2021

We look at the definition of inflation and explain how it might affect investments.

Since the start of the year there have been some days when stock markets have been somewhat jittery. Government bond markets have been rattled too (a government bond is effectively an IOU, whereby an investor lends to a government for a set time-period in return for a fixed rate of interest). In part, the increased nervousness has been over investor fears of an increase in inflation. But what is inflation and how does it affect investments generally?

Inflation –the definition

Inflation is a sustained rise in the prices for goods such as food, clothing and oil, as well as services such as air fares and rail tickets. It’s expressed as a percentage increase or decrease. It is often regarded as a measure of financial wellbeing as when wages don’t rise as fast as the rate of inflation, the standard of living falls.

UK inflation and the pandemic effect

Currently, inflation in the UK is running at its fastest rate since the start of last year’s lockdown in March 2020[1]. Back then, whole swathes of the economy, most notably shops and restaurants, were shut down, while air travel came to a near standstill. As demand for goods and services fell sharply so too did things such as the price of oil, clothing and footwear (all of which are included in the inflation calculation).

With lockdowns now easing and the UK economy recovering in line with many others, the reverse is true. Households are more willing to spend some of the savings they’ve built up during the pandemic. And just as demand for goods and services increases, so do their prices – especially when certain goods and services have been very difficult to get hold of during the pandemic. The key question economists are asking is whether inflation is here to stay or whether it’s purely temporary as we return to normality after the pandemic.

How does rising inflation affect stock markets?

While a moderate amount of inflation typically is less harmful to stock markets than government bonds (see below) it nevertheless can slowly erode the value of stock market investments over the longer term. For example, suppose your investment returns a steady 3% a year. When the rate of inflation is around 1% the investment will still return an inflation-adjusted 2%. If the rate of inflation increases, however, to 3%, your same investment in the stock market will return an inflation-adjusted zero.

How does rising inflation affect government bonds?

Typically, inflation negatively affects government bonds in two ways through:

  • Reducing the actual price of the government bond, so it’s worth less.
  • Eroding the value of the fixed interest payment which the government bond pays out, and which is also known as the coupon.

The bottom line is that whether you notice it or not, inflation tends to eat away at the value of everything – and long-term investments are not immune from this trend. The key, as ever, is to keep an eye on your investments and plan accordingly.

Remember, the value of any investment is not guaranteed. The value of investments and any income received from can go down as well as up and you may not get back as much as you had originally invested.

[1] Source: BBC news as at 19 May 2021.