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The consequences of inflation when investing for retirement

7 months ago

Confidence in a post-pandemic recovery continued to grow throughout 2021, boosted by vaccines and stimulus packages. Optimism over the reopening of the world’s economies could result in above average growth for the next few years. Along with this, expectations were building for a pick-up in inflation – and those approaching retirement should think seriously about protecting their savings, which can often fail to keep up with the rising cost of living.

Understanding how inflation could affect an investors retirement strategy is essential in ensuring they have enough assets to last them through their retirement years. We take a closer look at the consequences of rising inflation, a topic which is already dominating the headlines.

Government bond markets had been called ‘sleeping giants’ since the Great Financial Crisis of 2008

Central bank QE or bond buying programmes kept bond prices supported and yields at record lows since 2008. A huge number of bonds even had a yield below 0% or a negative yield. Over the same period, inflation was also dormant, so all was good. But the unprecedented level of fiscal or government stimulus we have seen since the Covid-19 pandemic struck, has boosted demand sharply.

Government bonds reacted first, as so often the case historically

This type of stimulus has a more direct impact on consumers’ spending power, meaning everyday prices start to rise, causing bouts of inflation.

A higher rate of inflation normally requires higher interest rates in the economy. For bonds that means higher yields, compensating for the negative effect of inflation on income. As bond yields rise their prices fall.

For equities the picture is less simple

A steady increase in inflation, however, can imply growth in the economy, with rising demand, employment and consumer spending. It’s preferable to deflation, which has the opposite effect. Growing demand allows companies to raise their prices, increase profits and pay higher dividends. This is particularly true of cyclical companies, whose earnings are heavily dependent on economic growth.

The problem comes with very high growth companies, whose best years of dividend payment are some way in the future. Financial markets use a yardstick based on longer term bond yields in order to value them. If those yields go up, then the potential future value of the company is adjusted downwards. And that’s why the tech heavyweights in the US and China have fallen sharply at some points this year.

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