The Good, Bad, And Ugly Of Inflation   May 21, 2018


Inflation

Black magic!

It’s a symbol of evil.

Long black hair!

It’s the top-selling slogan of the whole hair cleansing industry.

So whether the word black is used to denote ‘fair’ or ‘unfair’?

Well, depends on the context.

The same is true about inflation.

Some countries of the world are trying hard to accelerate the inflation.

It means inflation is certainly not a taboo.

But others are struggling to keep this devil locked in the bottle!

So what decides its danger quotient?

The simple answer is: quantum of its spike and likeliness of its sustainability.

But in the investor community, at least in the developing countries, rising inflation is taken a negative for investments. Is it just a belief, or it has any historical evidence as well?

Let's first understand what inflation means in the true sense.

In plain English, continuous rise in the prices at a broad level is inflation. It is best described by an economical situation: too much of money chasing too few goods and services.

When the gap between demand for goods and supply of money is too high, it causes prices to rise at a breathtaking pace. While a low to moderate gap results in a steady but minimal rise in the prices.

So the inflation is good if…

Prices rise moderately.

Wondering why?

That’s the time when companies invest more in their businesses to ramp up production to meet the ‘higher’ demand for goods. During this time, more manpower is needed which pushes wages upwards. Money invested in production capacities fetches higher returns, which in turn accelerates the shareholders’ returns as well.

But the real danger appears when the demand is so strong that despite investing massively in production capacities, corporations usually fail to meet the demand. That’s when the prices of goods and services become almost unaffordable.

As a result, the discretionary income of the majority of households falls. They can now buy lesser goods. Companies suddenly realise that they went overboard with production during the boom time. They soon start realising their overheads are unsustainable. They lay off people.

As people lose jobs, demand for goods and services falls again, followed by the price reductions which someday jumpstarts the economic upswing again.

Inflation is high during the developing phase and vice-a-versa
Time period between Average inflation in the U.S.
1968 and 1978 6.0%
1979 and 1988 6.6%
 1989 and 1998 2.8%
 1999 and 2008 2.2%
2009 and 2017 1.8%
Non-food and non-fuel inflation is considered
(Source: U.S. Bureau of labour statistics)

How much inflation is good?

That depends on the growth phase of the economy and the rate of inflation elsewhere in the world. Usually, developing nations witness sharp swings in inflation and cost of capital.

For instance, the world’s largest economy, the U.S., saw higher inflation during its growing years. But, as the economy grew, inflation cooled off.

Economic prosperity reduces price volatility
Economic prosperity
Non-food and non-fuel inflation is considered
(Source: U.S. Bureau of labour statistics)

Over last 50 years, inflation in the largest economy of the world has averaged at 4.1%. Higher inflation for the prolonged time makes the capital costly. And with rising interest rates, returns generated by the debt fall.

Over last 50 years, 10-year Treasury Bills in the U.S. have fetched 7.1% returns on an average. Out of 50 years, they have generated negative returns for 21 years. The worst negative performance has been in the year 2009. While 1982 has been the best year for bond investors when the 10-year Treasury Bills generated 32.8% annual returns.

Stock market performance
Stock market performance
(Source: New York University)

Over last 50 years, S&P 500 has generated 11.4% returns on an average, which is indicative of equity as an asset class makes a higher inflation-adjusted return as compared to debt.

The best performance of the index came in the year 1995, when the index rose 37.2% in a year. Whereas, 2008 was the worst performing year for the index when it lost 36.6%. Interestingly, the index has generated negative annual returns only on 10 occasions in last 50 years.

Impact of inflation on employment
Impact of inflation
(Source: U.S. Bureau of labour statistics)

Impact of inflation on goals

Higher inflation demands more money to satisfy our financial goals. At worse, if inflation spikes up for any reason at a time when your goal is up for the fulfilment, it is more than likely to disappoint you.

Therefore, make a point to be conservative about the estimation of return on your portfolio and be cautious about the estimate of inflation.

Many of you might be wondering, why we haven’t considered the impact of inflation in the Indian context. Just because, India is still a developing economy and if you assume the three-decade-trend will continue for the next 30 years, you are perhaps saying that the Indian economy may not grow as ferociously as expected.

For your information, average inflation for the last 30 years has been 7.3% in India. At present, the country is targeting 4% inflation over the medium term, which has almost been at par with the average inflation the U.S. economy experienced in last 50 years.  

To beat the inflation bug, make sure you invest in productive investment avenues such as equity mutual funds that are tax efficient than some traditional bank fixed deposits.

Endnote

Inflation isn’t good or bad on its own. Other factors make it a boon or a bane. Don’t get trapped between a rock and a hard place. On the contrary, have a financial plan in place to tackle the high-inflation effectively, and make the most of it when it’s moderate.

Want to draw a comprehensive financial plan to accomplish your financial goals?

Schedule a Call with PersonalFN’s investment consultant or drop a mail at info@personalfn.com and we will get in touch with you. You may also call us on 022-61361200.

PersonalFN is a SEBI registered investment advisor. We will be happy to help you.

Author: PersonalFN Content & Research Team



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