Inflation, Inflation, Recession, Recession, let’s just call the whole thing off?

Ian Wood, CFP, CIM, MFA-A

We find ourselves in an unusual situation with higher-than-normal inflation while simultaneously seeing signs of either an ongoing or approaching recession.  It’s not a time for knee-jerk overreactions.  Rather, the current cloud gathering should come as a reminder that long-term wealth is built by well-researched investments constructed around the realities of fluctuating economic circumstances.

The current high levels of inflation we are experiencing appear to be caused by two major factors: supply shortages and government spending.  While politicians argue the proportional significance of each factor to overall inflation, we will move on from the controversial question to focus on the facts at hand and how we can plan ahead with the information we have available. That is, inflation is near the highest point we’ve seen in almost 40 years.  So what do we do about it?

Investments with level payments, such as GICs, bonds, and non-indexed annuities, may provide a predictable source of income; however, as inflation increases, the purchasing power of the income provided decreases with each passing year.  The safety in the predictability of the payments comes at the cost of exponentially lower purchasing power over time, often with a lack of flexibility to make changes as circumstances change.

Alternatively, investing in quality companies that pay a dividend and have a history of growing their dividends can provide a good source of inflation protection for an income-generating portfolio.  Unlike bond interest, dividends can increase over time as the profits of the companies rise.  A well-designed portfolio could have seen average of 8-10% increases in dividends each year in the past, exceeding even today’s higher inflation figures.  The investor’s risk tolerance needs to be sufficiently addressed to ensure investing in equities is suitable for them based on the goals for the account.

Central banks have started to act by raising interest rates to cool inflation concerns.  Higher interest rates make it more expensive to borrow money to spend, which reduces demand, which reduces inflationary pressure on prices.  It’s important to note that rising rates might not reduce prices of goods and services but should have the impact of slowing the rate of change in price increases going forward. 

Higher rates are a challenge for highly-leveraged companies that require debt financing to grow.  However, mature companies with less debt will be less effected by the rise in interest rates.  Some companies, like banks, may be well positioned to benefit from higher interest rates as they can profit from the increased spread between saving and borrowing rates.

The Bottom Line for Advisors and Their Clients.  Looking at the short, medium and longer-term outlook for inflation is important in making investment decisions.  Advisors should review asset allocations and determine whether the portfolio is likely to provide a growing source of income that can keep up or exceed inflation.

Next Time:  Anticipating Recessionary Pressures in Investment Planning