How high inflation and interest rates affect investments

The past couple of years have been the first period in a generation when investors have had to think seriously about the effects of high inflation and interest rates. These effects have been far-reaching in areas from mortgage lending to bond and equity (share) markets.

Following more than a decade of low inflation and ultra-low interest rates, with UK interest rates at less than 1 percent, inflation began to re-emerge during the Covid-19 pandemic. The transportation and distribution of goods became disrupted globally and many items became harder to buy, which led to rises in their prices.

This was intensified in 2022, when Russia launched its tragic invasion of Ukraine. Ukrainian agricultural production was reduced, while sanctions limited the supply of Russian oil and gas. In consequence, the supply of these key commodities was disrupted, leading their prices to rise. When businesses that relied on these commodities tried to pass on these rising costs, prices for consumer goods surged throughout the economy. This was reflected in higher inflation, as inflation is a measure of rising prices.

In the UK, inflation reached a recent peak of 11.1 percent in October 2022, although it stood at 4.0 percent in January 2024 (1). The Bank of England (BoE) responded to high inflation by raising interest rates. This is perhaps its most effective tool for reducing inflation. By making borrowing more expensive, consumers have less to spend and so demand is reduced for goods and services. This, in turn, helps bring down prices and inflation.

Impacts on investments

When inflation rises, we need to consider the difference between prices in ‘nominal’ and ‘real’ (or ‘inflation-adjusted’) terms. If an investment rises in value at a slower rate than the rate of inflation, then its owner will be worse off in real terms. This is because the increase in value is more than offset by the decrease in what you can buy with it.

Similarly, if you’re earning 4 percent interest in a savings account but inflation is 5 percent then your spending power will fall in real terms. This is because the 4 percent rise in the value of your cash would be more than offset by the 5 percent fall in what you can actually buy with it.

Inflation affects different investments in different ways. So, in an extended period of high inflation, a bond promising to pay you £1,000 in the distant future will have less buying power than one paying you £1,000 today. In consequence, the price of the bond with the long expiry date could currently be worth less than the one expiring today.

Declining bond values is something some investors have recently experienced for themselves. Even so, investors could potentially benefit from bond investing during periods of high inflation if they expect inflation to fall before the bond expires. That’s because interest payments on bonds are typically high during periods of high inflation and they would remain high even after inflation fell.

Complex effects on shares

The impact of inflation on equities (shares) is more complex, as it depends on several factors. All else being equal, if a company’s costs and the sale price of its products move in tandem, then its share price could rise at roughly the rate of inflation. So equities can sometimes provide protection against inflation.

One key factor could be the company’s ability to pass on higher prices. Consider a company struggling with rising global prices for oil and other commodities but whose cash-strapped customers could easily switch to substitute products. This company would face higher costs but wouldn’t be able to raise the prices of its own products. So its profits would fall and its share price could also decline.

Impact on different types of companies

Growth stocks are typically negatively affected by inflation. Growth stocks are companies expected to grow at a rate significantly higher than the market as a whole and can include technology companies. Their share prices appear expensive relative to their current profits, sales and annual dividend payouts (if they have any), as investors instead expect them to make significant profits in the future. But if these expected future profits could be eroded by high inflation, then the share price may fall.

Moreover, a rise in interest rates to combat inflation could also negatively impact growth stocks. Growth companies often borrow heavily to fuel their growth and high borrowing costs can erode their profits.

In contrast, an inflationary environment can have a smaller impact on value stocks, which are companies whose share prices appear cheap relative to current profits, sales and dividends. Value stocks are typically found in areas such as financial services, oil and gas, and machinery manufacturing. Their profits are expected to grow slowly or reduce over time, so they would be less affected by high inflation than growth stocks.

Benefits of long-term investing

At Schroders Personal Wealth (SPW), one of our key principles is to invest for the long term. We also believe in not putting all your eggs in one investment basket, but rather to invest in a diversified portfolio with a level of risk appropriate for your circumstances. This can help reduce exposure to particular investments that might struggle with economic factors such as high inflation. And it can give time for investments to grow and, hopefully, beat inflation. As we say at SPW, investing is about spending time in the markets rather than trying to time the markets.

Source:

(1) Statista (www.statista.com), ‘Inflation rate for the Consumer Price Index (CPI) in the United Kingdom from January 1989 to January 2024’, 14 February 2024.