Inflation has risen sharply since 2020, largely due to explosive economic growth since the initial economic downturn following the onset of the COVID-19 pandemic. To add fuel to the inflationary fire, supply-chain issues are creating goods shortages that are persistently plaguing businesses trying to meet sharply increasing demand from consumers and businesses.
Cost of a dozen eggs over the years
1. Source: Statscan, Bank of Canada.
2. Source: Statscan, Bank of Canada.
3. Calculated using projected annual inflation of 2%
Recent data has shown that inflation rose sharply in 2021, reaching almost 5% in the final quarter of the year, a level not seen since the early 1990s. Understandably, rising prices are a serious concern for Canadians, as the cost of everything from gas to eggs to Internet services soars.
Inflation: The Great Deflator
Alongside inflation’s impact on consumer prices is its impact on investors. Rising inflation will have different effects on different asset classes, but it generally tends to have a greater negative impact on fixed income and cash returns than equities, as follows:
On a relative basis, inflation can have a bigger effect on cash and bond returns*
- Fixed income: These investments generate “fixed” returns, so as inflation rises it erodes those fixed payments, eating up more and more of an investor’s after-inflation real return. The double negative for fixed-income investments is that, as inflation rises, central banks tend to raise interest rates, which often ripples through to the bond market, raising yields. As rates and yields rise, the price of fixed income products falls (prices and yields are inverse), resulting in an even more negative impact to investors.
Despite inflation, fixed-income investments play an important role in managing risk within a diversified portfolio over the long term, particularly as they can provide stability in volatile markets. As well, different bonds respond differently to various market conditions, so a well-diversified, risk-appropriate fixed-income portfolio that takes advantage of the many options available today, such as corporate bonds, can help mitigate the impact of rising interest rates. - Equities: Historically, inflation occurs when there’s strong consumer demand and business growth, which in turn drives up company revenue and profits, leading to generally positive equity returns. Equities (or stocks) of companies in financial, consumer staples and energy sectors often do particularly well during inflationary periods.
The risk for equities is that central banks raise interest rates too sharply in their efforts to limit inflation, inadvertently triggering an economic downturn. However, RBC investment strategists currently view that risk as low, and forecast continued economic growth. And again, diversification is key with equities, as different types of equities do better in different economic environments.
Concerned about inflation and its impact on your portfolio? Talk to us today about how we can help you manage the latest inflation conflagration.
*Source for returns: Morningstar Direct, RBC GAM. 20-year investment returns data as of June 28, 2021. For illustrative purposes only. Cash: FTSE Canada 30 day T- Bill Index. Bonds: FTSE Canada Universe Bond Index. Equities: S&P/TSX Composite TR Index. The indicated rates of return are the historical annual compounded total returns for the periods indicated including changes in unit value and reinvestment of all distributions. Index returns do not reflect deduction of expenses associated with investments. If such expenses were reflected, returns would be lower. An investment cannot be made directly in an index.
Source for inflation data: Bank of Canada for the average inflation figure of 1.8% (annualized) as of June 28, 2021. Inflation is approximated by the change in Consumer Price Index (CPI) each month.
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