How inflation impacts your investments

When prices for goods and services rise rapidly, it can have a big impact on businesses and the cost of living for Canadian households. While the immediate sting to our wallet is usually the most painful – at gas stations and grocery stores, for example – extended periods of inflation are felt through most corners of the economy.

So, when it comes to your investments, is inflation something to worry about? As with any aspect of the financial markets and the economy, a little perspective can go a long way. Below, we explore what inflation and rising interest rates could mean for you and your money.

What is inflation?

There are numerous indicators that help economists and investors monitor the overall health of the economy; unemployment and job-growth rates, gross domestic product (GDP), and trade deficits and surplus, are just a few. Not only is it an extensive list, but each can tell a different story at a specific point in time, adding to the layers of complexity.

At its most basic level, inflation measures how prices change over time and how that relates to the “purchasing power” of money. In other words, how much does a given amount of money buy over time?

Inflation is often represented by the percentage change in the consumer price index (CPI), which measures the cost of a basket of 700 select goods and services, including groceries, gasoline, furniture, clothing and recreation. The Bank of Canada’s current mandate is to keep inflation (or the increasing cost of that basket) between 1% and 3%, annually. To do that, it uses the policy tools it has at its disposal, including the power to change interest rates.

What drives inflation?

There are many causes of inflation. But prolonged episodes of high inflation are often the result of “loose” monetary policy, which can include low interest-rates. Let’s use Canada as an example: if the amount of money in circulation (the money supply) grows too large relative to the size of the economy, the value of the Canadian dollar declines relative to other currencies around the world. As Canadians, that weakens our purchasing power around another country’s goods and services – especially if that country’s prices rise compared to our dollar.

Another common phenomenon that can spark inflation is “quantitative easing.” As part of this monetary-policy strategy, central banks buy longer-term securities (such as government bonds) from the open market. This removes assets from circulation and injects money into the economy – or, more specifically, into the hands of businesses and consumers – to encourage buying, lending and investment. Quantitative easing was the main tactic used by the world’s central banks throughout the COVID-19 pandemic.

Finally, pressures on either the supply or demand side of the economy can be inflationary. Supply shocks that disrupt production, such as natural disasters, pandemics or rising costs, can reduce supply levels. Conversely, demand shocks, such as a stock-market rally or expansionary economic policy (like central banks lowering their policy interest rate or a government increasing its spending) can temporarily boost demand levels and overall economic growth.

How does inflation relate to interest rates?

In early 2022, with the economy running hot and the labour market fully recovered from the effects of the pandemic, the Bank of Canada began raising its policy interest rates to manage inflationary pressures. Rates are reviewed by the Bank of Canada eight times per year. The main goal is to increase the cost of borrowing, making loans more expensive (and harder to pay back) for both businesses and consumers. With that, raised interest rates simultaneously encourage people to save money for lending (i.e., investing), so they can earn a higher rate of interest and generate a higher return.

Overall, less borrowing and more investing reduces the supply of money in circulation, which cools economic activity and naturally lowers inflation.

What does this mean for your investments?

Rising interest rates can negatively impact the stock market. When rate hikes make borrowing money more expensive, the cost of doing business rises for companies. Over time, higher costs and less business activity could mean decreased revenues and reduced bottom-line earnings for companies, potentially hindering their growth rate and their stock’s value. More immediate, however, is the impact that rate increases have on market psychology – how investors feel about current and future market conditions. Significant increases often promote a shift toward a more risk-averse mindset, reducing equity returns overall.

Bonds are particularly sensitive to interest-rate changes, as many pay a fixed rate of interest. When rates are increased, the market price of held bonds immediately decline. This is because new bonds will soon be issued to the market, offering investors higher and more-attractive interest-rate payments to encourage buying. Likewise, responding to these higher overall rates, existing bonds typically experience a decline in price to make their comparatively lower interest rate more appealing to investors. In general, the higher the duration, the more a bond’s price will decline as interest rates rise. Therefore, during a period of rising rates, it is beneficial to hold bonds which exhibit lower duration, to reduce exposure to interest-rate risk.

Want to learn more about stocks and bonds? Read the article What are investment funds made of?

What can you do, as an investor?

The best way to guard your money against inflation is to ensure that you have a solid financial roadmap – including clear goals as well as a diversified investment portfolio, with some exposure to equities – in place. The equities will provide an opportunity for growth, while the fixed-income assets may act as a counterweight. (The ratio of fixed income to equities will depend on your risk tolerance and investment objectives. A Co-operators financial representative would be happy to help you find the right balance.)

If you’re retired and fixed income is part of your financial plan, it’s especially important to talk to your advisor regularly to ensure that your investments are managing inflation.

Remember, it’s always a good idea to save more than you think you’ll need. And to start as soon as you can, so you maximize the power of compounding growth. It’s also important to reduce personal debt by as much as possible, so you can keep up with payments if interest rates rise.

At Co-operators, any mutual funds or segregated funds that we recommend are based on your personal situation and investment profile, while the composition of each fund is chosen by a professional money manager to meet its objective. That means all your investment risks are factored in, including inflation.

For more information and resources, visit Market View and Resource Centre. You can also read our weekly Investment Update for deeper insight into the latest news driving financial markets.