Tackling inflation with investments
Inflation is one of the most commonly used economic terms these days, but what does it mean in the context of financial markets and investing? Despite the constant noise on macroeconomic news and events, it rarely offers a meaningful prognosis of where the stock market is going. To manage our wealth and expenses better as individuals, we have to understand how inflation works, and how it affects the financial market.
Relationship between inflation and the markets
Inflation is a general, broad rise in prices for goods and services but the interactions between inflation, interest rates (i.e. Fed policy) is pretty complex. If we use classical economic frameworks, then inflation is caused by an imbalance in demand and supply. So either demand is too strong or supply is low and recently the spike in inflation has been caused by a combination of both.
When the central banks raise interest rates, the cost of money increases. The cost of servicing any borrowing or loans increase. Our mortgage rates rise, rent increases, and we have less ability to spend. Higher interest rates can be called a tax on consumption and income. Higher interest rates can therefore curb inflation that is driven by higher demand for goods and services.
Now if we look at the impact on financial markets, the value of any company is the value of all the future cash flows discounted back to a present value by its cost of capital. Higher interest rates mean companies are likely to be worth less as the discount rate increases and the present value of that future cash flow decreases. There may be a positive impact from an increase in nominal profits and cash flow but it is often offset by an increase in the cost of capital especially if interest rates rise rapidly as they are now.
Investors should note that rising interest rates may lead to a short-term stock market downturn for this reason and despite the fact that the underlying economy and demand remains strong, the medium to long-term effects of raising interest rates take time to play out in slowing demand. Therefore, often the markets, as a leading indicator, have already reacted and priced in the slowdown in demand or a recession before a recession becomes official or the impacts have fully played out in the economy. Economies go through cycles and the cycle of interest rates and inflation have both surprised on the upside. But the cycle will turn and we will start seeing interest rates start to stabilise and go down again as inflation eventually starts coming down again. As with all things, the difficulty lies in the fact that we cannot predict the future and it is notoriously difficult to not only predict but also time the market.
Singapore’s history with inflation
Looking back at Singapore, younger Singaporeans might have the impression that the Singapore government has managed to keep a tight rein on inflation in the past. The historical data tells a different story.
Singapore’s Consumer Price Index has fluctuated since Singapore’s independence. Although the government has managed to keep inflation below 2% recently, inflation rates were above 3% for 15 calendar years between 1961 and 2021.
Our economy is dependent on imported goods and services, and we are susceptible to rising global prices with few levers to negate its impact. To be responsible for our retirement, not only do we need to conscientiously save for it, we should also invest.
Going risk-free is a sure-lose approach
Investors should also be wary about holding too much in cash or cash-like instruments, such as SSBs, T-bills or fixed deposits. With risk-free products currently yielding above 2% per annum (p.a.), it is often more tempting for an investor to hold cash than to risk it by investing in the markets.
Looking backwards, we might think that POSB's “risk-free” interest rates of 6% p.a. in December 1980 made savings the perfect “investment”. However, the inflation rate in 1980 was 8.5% p.a., so savers were effectively losing 2.5% of their wealth per year by investing their deposits with POSB.
Thus, during periods of high inflation, achieving high nominal returns may still result in negative real returns, and this strategy is certainly not a sound retirement plan. This concept of nominal and real returns is an important concept to grasp. Nominal returns mean the yield or financial returns that an investment or interest rate gives you. Say you have a 5% nominal return. However, the real return (adjusting for inflation — or more importantly, the cost of living) with an inflation rate of say 6% is actually a negative -1%. Therefore, having a low-yield or return product and locking it in is a sure way to generate negative yield or negative return.
How should Singaporeans invest against high inflation?
Many survey respondents are inclined to use savings products to tackle inflation. While these vehicles provide some returns (~2%+ p.a.) against inflation, they should only be used for short-term savings, such as emergency funds or to fund an expense three months down the road.
Singaporeans should instead take a goals-based approach to wealth planning, matching the investment horizon of their financial goals against the risk levels of different financial products. This approach can help investors stay invested despite short-term market conditions.
For longer-term financial goals, as a rule of thumb,
- If you have 2 to 5 years, invest in a portfolio of 40 per cent global stocks and 60 per cent global bonds
- If you have 5 to 10 years, invest in a portfolio of 80 per cent global stocks and 20 per cent global bonds
- If you have over 10 years, you can take up more risk and invest even up to 100% in global stocks.
The reason is that the longer you invest in both equities and fixed income, the distribution of outcomes (the probability that the returns are very wide — from large positive to large negative numbers) declines and the return becomes closer to the long-term average return on an annualised basis. So the probability of success in achieving a good outcome continues to increase the longer you invest.he average return of equities and fixed income in the long run also tends to beat inflation, especially with equities. Hence, with a longer investment horizon, you can afford to own more equities but in the shorter term, fixed income provides the diversification to lower the volatility and risk of the portfolios. A globally diversified portfolio and one across asset classes is a better protection against inflation and increases your chance of gaining a positive real return in your portfolio.
Endowus offers a suite of investment products for different investment horizons. These can be invested across Cash, CPF, and SRS in a single platform so Singaporeans can have a bird’s eye view across all of their investments. It uniquely offers expert advice, access and cost — the three key building blocks to long-term investing success.
For new investors, our Flagship Portfolios offer broad-based diversification across geographies and sectors, being invested in more than 10,000 stocks and 6,500 bonds.
For investors who are looking for a source of passive income, instead of picking and managing single REIT holdings, you can consider the Endowus Income Portfolios. These multi-manager portfolios pay out monthly passive income that requires no active management from you.
Despite the looming recession, we should all note that the markets are forward-looking, with tens of millions of market participants across the world pricing any positive or negative macroeconomic news and expectations in market pricing, in real time. When we invest for retirement, time is our greatest ally. With the very real threat of prolonged inflation, we must take on this long-term perspective in starting to invest in the right way to grow our retirement wealth now.Let the power of compounding work for you, not against you.
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