India’s retail price inflation moved up to 5.03 percent for February 2021. No one likes price rise – it means you have to spend more on the same basket of goods you buy.
Throughout 2020, retail prices in the economy have remained high. There was some relief in the previous three months as prices fell and inflation came in lower.
However, once again, conversations around rising inflation have picked up steam. Events in global economies and the dynamics of India’s economic activity are the key reasons.
Clearly, inflation impacts your spending pattern. You may be forced to cut back on frivolous spends when goods turn expensive. But, is there anything you can do differently when it comes to your investments in an inflationary environment?
How does it matter?
Your investment portfolio must be geared to beat inflation over longer periods.
However, can you do anything about short-term fluctuations? Over the last 30-35 years, annual inflation in India has been 3.5-13.5 percent, which means it’s not a stable figure year on year.
High inflation can result in higher interest rates. Often equity markets fall as a result of higher rates, given that corporate earnings suffer due to increase in their cost of capital. At the same time, your bank deposit rates may start to look up in inflationary periods. The opposite tends to happen in times of low inflation.
This might seem like reason to start switching investments, but you must consider the larger picture before doing so.
-High deposit returns in inflationary periods may be misleading: In 2008, the one-year fixed deposit rate offered by SBI was close at 9.5-10 percent a year. This looks very attractive when seen in isolation. But did you know that the annual inflation in 2008 was above 9 percent. In 2009, it was close to 12 percent. Had you switched to these ‘high interest’ paying deposits, you would have ended up making negative real returns, as inflation was higher than the interest rate.
-Don’t get carried away by rising asset prices during low inflation: In recent years, inflation has largely remained subdued as economic growth across large-sized economies has been sub-optimal. As a result, financial and physical assets such as equities and commodities have been bought into.
Low inflation is accompanied by low interest rates and that can also help keep such asset prices inflated for a while.
You may be tempted to switch out of low-yielding bank deposits to assets with higher returns. Keep in mind that while soaring equity market returns might look attractive, in times of low inflation, your money’s worth remains more stable and you don’t have to pile on high risk in a bid to earn high return.
What should you do?
While you should be aware of how inflation impacts both your short and long-term investment portfolios, you don’t need to shuffle your assets needlessly in the short term, just because of inflation trends in the economy.
Your long-term investment strategy needs to be focused on growth assets to protect portfolio returns from getting eroded by inflation. Real estate can also help grow wealth over time, despite inflation. Be mindful of the typical characteristics of each asset before investing. In periods of low inflation, speculative assets and financial products get a boost; be careful not to chase those.
The short-term equity market trend might get disturbed by inflation expectations, depending on whether interest rates rise faster than corporate earnings. However, you must stick to your long-term allocation rather than switching out during short term market corrections, which may result partly from an uptick in inflation and interest rates.
For your fixed income assets, high inflation can eat into any rate hike advantage you may get on your deposits. When deposit rates fall due in low inflation periods, switching to higher risk assets in search for higher return can lead to capital loss.
Ignoring the impact of short-term rise or fall in inflation rates on your investment portfolio.