Inflation: Why it matters to companies and how to deal as an investor
Inflation may drive significant changes in value, but those changes are generally not felt equally across the board.
Inflation is a rise in prices for goods and services and is commonly cited as a negative factor. However, price fluctuations are always present. They only become financially significant when they become unusually large, fast, and widespread.
The Bureau of Labor Statistics measures it through the Consumer Price Index (CPI), which monitors the cost of goods like fuel, food, clothing, and automobiles to determine the overall price change of consumer goods and services.
How price changes can impact the balance of assets and liabilities
Inventory and assets are valued at either purchase cost or replacement cost, whichever is less. They could be undervalued or overvalued depending on market prices, which may affect reported operating results.
Inflation may take longer to be felt on non-liquid assets like property and equipment. Depreciation schedules use the actual cost and continue as long as the asset is used. Replacement cost inflation affects the asset when a new one is put into service. Deflation would have the opposite effect.
Current assets like cash and accounts receivable are immediately impacted by changes in purchasing power. Inflation and inflation fears can also affect foreign exchange rates, potentially offsetting or amplifying inflation's effects on currency translation gains or losses.
How inflation can change the flows of income and expense
The impact of changes in price levels on revenue depends on factors such as price flexibility, sales turnover, and pricing power. Companies that rely heavily on large deals with multi-year revenue streams may find it difficult to offset the loss of purchasing power of revenue over the life of the contract. Conversely, an increase in the purchasing power of future income can reap the benefits of a windfall.
Companies that continually sell new products can more easily adjust their prices to respond to changes in the purchasing power of their customers. Of course, a price increase can promise higher profits, but such discussions assume that the company has the bargaining power to increase its prices even if one or more competitors do not adjust their prices. The impact of price level changes on the expenditure side of the ledger depends on factors such as the ratio of cash and incurred expenses, and the amount of inventory and work in progress that can be carried over from year to year.
A business that constantly buys raw materials at current prices could see its costs of goods sold respond relatively quickly to changes in the economy's price level. A business that accrues large fractions of its costs by depreciating prior investments could see less immediate cost effects as older investments are consumed. A product with a short production cycle may have a relatively small impact on the cost of a given unit. However, companies with multi-year production cycles may incur cumulative costs that lag behind current price levels. Interest costs can vary based on fixed-rate or variable-rate interest, rising or falling with inflation or deflation.
How inflation changes the market:
In the broadest sense, inflation can increase interest in immediate consumption over delayed rewards. This is particularly evident in the consumer sector of the economy, where the value of buying something before prices rise can outweigh the urge to save for the future. On the other hand, if consumers believe that the same product will be significantly cheaper in the near future, they may have less desire to consume quickly.
Assets with fixed long-term cash flows tend to underperform when inflation rises since the purchasing power of these future cash flows diminishes over time. Conversely, cash flow regulated commodities and assets tend to perform better when inflation rises.
What should investors do about inflation?
The importance of inflation to investors is manifold. It can decrease the value of your portfolio due to the dollar’s devaluation. As the dollars worth decreases, so does the total worth of your investments.
In general, stocks tend to be more volatile during periods of high inflation. While value stocks do tend to perform during inflation, growth stocks, on the other hand, generally see better returns during periods of low inflation. This is because value stocks have strong cash flows that slow over time, while growth stocks have little or no cash flow, but investors expect this to change over time.
To hedge against inflation you need to diversify your portfolio by investing in a wide range of alternative assets. Additionally, some investors choose to invest in financial instruments strategically designed to hedge against inflation, such as low-risk Treasury Inflation-Protected Securities (TIPS), as well as certain mutual funds and ETFs that can help to protect your portfolio.
Defending your portfolio against inflation:
Inflation can have a significant impact on your portfolio over time. In In addition to working with a financial expert, consider two steps that can help protect your investments from inflation:
- Diversifying your portfolio with exposure to U.S. stocks and real assets may help you shield your money against inflation. However, diversification and asset allocation do not protect against losses or guarantee returns.
- Consider Treasury inflation-protected securities (TIPS). The rate of return on TIPS, issued by the U.S. government, is adjusted in accordance with the CPI. This can result in a somewhat more reliable performance than other types of bonds and asset classes. However, TIPS returns and income tend to be relatively low.
For investors, it is important that the returns on their investments are at least the same rate as inflation. Inflation may be out of your control, but that doesn’t mean you can’t take actions to help protect your investments and savings.
Tiffany Lalremruati
