International investors face many unique risks such as political risks and currency risks. Inflation represents another very important risk to understand as it can have a profound impact on the economy. This is true not only in unstable countries like Zimbabwe where inflation reached 2600.2% in 2008, but also in advanced markets around the world.
Impact of Inflation on Bonds
Inflation is likely to be evident in bond prices. These prices tend to have an inverse relationship with inflation, as high inflation leads to increased expected yields, and high yields lead to lower bond prices. Furthermore, persistent inflation reduces the value of the maturity payment (principal), as the value of that currency becomes increasingly diluted.
The impact of inflation on bonds can be seen in the difference between “nominal” yields and “real” yields. Nominal yields are the actual yields, while real yields represent the inflation-adjusted yields that borrowers pay to lenders. As inflation accumulates over time, these differences can add up to substantial amounts over time.
For international investors, sovereign debt and exchange-traded funds linked to sovereign debt worldwide are susceptible to changes in inflation. It is important for investors to monitor consumer price indexes (or unofficial special reports for those countries lacking reliable reports) to detect signs of rising inflation as this can represent a future problem for bondholders.
Mixed Impact on Stocks
While inflation may be a bad sign globally for the bond market, its impact on stocks is less certain. Excess capital can provide cheap loans to companies, which can stimulate economic growth and drive up profits. However, uncontrolled inflation can lead to problems for the entire economy, including the end markets targeted by companies.
Many economists say that moderate inflation between 1% and 3% leads to strong stock returns, while periods of high inflation at 6% or above always result in negative real returns for stocks. Of course, some argue that any level of inflation does not increase the return on equity visible in public companies, as it can be difficult to show direct cause and effect.
For international investors, central banks providing liquidity during crisis periods can bolster stocks by supporting economic recovery. However, inflation that seems out of control can lead to lower stock returns. Again, it is important for investors to monitor consumer price indexes (or unofficial special reports) and measure that against economists’ forecasts.
How to Hedge Your Portfolio
Investors can reduce their exposure to inflation risk using a variety of methods. The most common way to hedge against inflation is by purchasing fixed assets such as gold. Fixed assets include commodities like energy, precious metals, base and industrial metals, agriculture, alternative energy, and forest products. They are tangible assets with intrinsic value and generally tend to have a negative correlation with stocks and bonds.
Some developed countries also offer other forms of inflation hedging. For example, the U.S. Treasury offers Treasury Inflation-Protected Securities (TIPS) that adjust for inflation based on official Consumer Price Indexes. Similarly, inflation-protected government bonds in Europe have attracted some investors’ attention.
Note that these inflation-adjusted securities can also be an indicator of confidence in the government. For example, investors worried about the negative impacts of inflationary policies may opt to purchase inflation-protected securities instead of non-protected securities, which would create a growing gap between the two over time – a clear warning sign.
Sources:
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– Federal Reserve Bank of Dallas. “Hyperinflation in Zimbabwe,” Page 3. Accessed August 23, 2021.
– Treasury Direct. “Treasury Inflation-Protected Securities (TIPS).” Accessed May 5, 2021.
Source: https://www.thebalancemoney.com/the-effects-of-inflation-on-global-investments-1978969
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