The impact of inflation and deflation on investments

What you’ll learn:

• Why inflation matters for savers and investors
• Why deflation is bad for stocks
• Which investments suffer the most from bouts of deflation and inflation.

Depending on how your investment portfolio is positioned, both periods of inflation and deflation can have a significant impact upon how it performs.

Inflation, otherwise known as the rising cost of living, affects a wide variety of economic factors, from business and consumer spending to interest rates – all of which can markedly influence stock and bond prices.

In the UK, the Office for National Statistics (ONS) keeps track of inflation in the form of the Consumer Price Index (CPI) which tracks how the prices of hundreds of household items including food, alcohol and clothing, change over time. An alternative gauge often used is the Retail Price Index (RPI), which includes other costs not counted in the CPI, such as mortgage interest payments and council tax.

What causes inflation?

When an economy is expanding, consumers and corporations are generally financially better off and as a result they typically spend more. The upshot is that supplies can be squeezed and companies may start charging more for their goods and services. Rising demand for raw materials and commodities can also be a powerful inflation driver. For example, when the price of oil rises, the cost of petrol and diesel on the forecourts usually follows suit.

Impact on savings and investments

Often dubbed the ‘silent assassin of savings’, rising inflation does no favours for deposit accounts. For instance, if your savings account is paying you interest of 2% but the rate of inflation is running at 3%, the actual value of your money is shrinking in real terms as costs are moving up at a faster rate than the value of your cash.

Bond investors also tend to suffer during periods of inflation for similar reasons due to the fixed rate of income they provide.

However an inflationary backdrop can be very beneficial for shares, as firms often increase the prices of their products when their underlying costs start to expand. This can result in better company earnings and therefore higher stock prices.

But a short period of sharp and unanticipated inflation can spook investors too, as it could indicate a period of economic uncertainty is on the horizon and share prices may suffer as a result.

Deflation

While slowing inflation is known as disinflation, deflation occurs when costs are actually dropping. Although this might appear appealing, as your money will go further and the real value of your savings will increase, a sustained period of deflation can be very damaging. For a start, consumers watching goods get cheaper by the month tend to delay their purchases, especially on big-ticket items such as cars, in the hope that prices will fall even further.

As a result, a tail-off in spending can actually depress economic activity. Falling prices also heighten debtors' problems by increasing the real cost of their borrowing.

Impact on savings and investments

While a period of deflation will help boost the value of cash on deposit, it is generally bad news for investors in shares.

During a deflationary period, companies are often forced to cut their costs, while their creditors are unlikely to lift their own spending. A vicious circle can develop where consumption is depressed because of rising real debts, which exacerbates the situation. All this spreads across the economy leading to corporate revenue and profit drops, which can translate into pay cuts, job losses and lower stock prices.

Generally, those worst hit by falling prices tend to be those with high 'operating leverage', meaning they have high fixed costs – mining firms being a prime example. Corporations with high debt levels can also struggle as the interest rates on the loans they owe remain fixed while the cash flows they depend on to repay them, eases in the wake of the lower prices.

But some industries are better equipped to deal with periods of deflation. For example, technology companies are more used to coping with persistently decreasing selling prices and increasing costs. So a drop in costs caused by a deflationary environment can help boost profits.

However, while stocks tend to suffer during periods of significant deflation, bonds are likely to benefit as they pay fixed-income streams, which would become more valuable and attractive to investors as prices fall.

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The value of investments can fall as well as rise. You may get back less than you invest. Tax rules can change and their effects on you will depend on your individual circumstances.