HOW INFLATION AND HIGH INTEREST RATES AFFECT INVESTING
If you turned on your TV, opened a newspaper, or checked your phone at any point in the last month, it's very likely you saw the word inflation. Amongst all the pressing issues currently being discussed, inflation is always high on this list - and it’s easy to understand why.
In the last few months, we’ve all watched the prices of food, gas, and other everyday items go up and constant headlines about rising interest rates. Food prices have risen so high[1], even a person like me who loves food, doesn’t enjoy eating anymore!
As the pattern often goes, when something that causes concern happens, people inevitably panic and get concerned about their personal finances and wealth. This response is perfectly valid, but the question remains - will inflation and high interest rates affect your investments? And if so, how?
Before I answer these questions, let’s put these current events into context. I may be about to show my age here but stay with me. The last time the United States experienced rampant inflation like we are seeing today was between 1970 and 1984. Inflation was at its highest in 1980, the year my brother was born, and started to tame itself in 1982, the year I was born. Coincidence? I think not!
Just joking. However, what is not a joke, is that you may be surprised to learn that the S&P 500 was only down during 4 of these 15 years of high inflation. So what does this mean?
Everyone seems to be worrying about inflation, but the data shows that it doesn’t always spell disaster in the long term. In particular, it doesn’t always mean that you will have bad investment results. As I’ve discussed in previous blogs, there is a psychological side to money and the numbers side to money. This is the difference between what you think will happen and the reality of what actually occurs. As is often the case when it comes to money, or it often has been in my experience, the numbers win out in the long term. Let’s explore.
WHAT DO HIGHER INTEREST RATES MEAN TO MY INVESTMENTS?
Higher interest rates typically lower the price of what you normally value a stock, share of a company, or asset at. This is why, if you have shares, you may have seen them take a bit of a dip recently. To explain why this is happening, I’m going to give you a math lesson.
The fundamental way of calculating the price of a security[2] is using the following formula:
P = FV
(1+i)N
Where:
FV = the Future Value of an expected cash flow
i = the interest rate
N = number of years
P = Current Price
Simple math tells you that if you raise the value of i, you will lower the value of P. This is what we’re experiencing now. Higher interest rates increase the cost of capital, raising i, which then subsequently is lowering the price of securities today. With higher inflation, the Fed is raising interest rates to help slow its rise to a normal level.
But, what about the FV, or expected cash flow?
What does inflation do to my investments?
Great question! And, I believe this is the side of the equation that people tend to forget. I mean, simple middle school algebra is tough, right?!?!
This is why I like to drill into people, what you own is a piece of a business, not an intangible ticker that randomly fluctuates between 9:30AM – 4PM Monday through Friday. A businesses FV (or, expected cash flow) is a function of revenue (demand), and its profitability.
During periods of high inflation, as you are seeing with me and my disgust of high food prices, consumers tend to change their spending habits. Additionally, businesses that are also experiencing high input costs, will attempt to pass these costs onto consumers.
Weaker businesses (those with poor cash flow, low profitability, unproven business models, more commoditized in nature, weak balance sheets, high debt, etc.) should struggle during these periods as they aren’t able to pass costs onto the end consumer. Strong businesses (with strong cash flow, high profitability, proven business models, more specialized in nature, with strong balance sheets, etc.), however, often make it through periods of inflation well, and could get stronger as weaker competition goes away.
For example, if costs go up by 8.6%, what can businesses do?
The first option is to pass this price increase onto consumers. This can be done by increasing prices to align entirely with the rate of inflation (8.6%). The risk here is that you see a decrease in demand by the end consumer who balks at the higher prices.
The second option is to maintain their prices and take a hit to their profits. The risk here is this creates a high amount of pressure on profitability that may need to be offset in another area of the business.
The stronger businesses should be able to go with option 1, with minimal effects on demand. While the weaker businesses are stuck, struggling between option 1 & 2. Raise price, demand should fall, don’t raise price profits fall, creating potential downward pressure of the business.
This brings us back nicely to our investment philosophy here at Julius Wealth Advisors: Focus on investing in high-quality businesses and let them do the work for you. Let them solve the problem of inflation and interest rates while you sit and let your personal wealth grow over time. High-quality, stronger businesses, should be able to survive and potentially thrive during periods of inflation!
Remember Your First KISS?
I found it unfortunate (and potentially self-serving) that the world of finance and investing is often surrounded by a deliberate cloud of mystery. This works for many ‘supposed’ experts who use this as a barrier to entry and a tool to sell fear and ‘uncertainty.’ In my opinion, the truth about finance and personal wealth is in fact not too far away from what I discussed in my recent podcast. Just KISS (Keep it Simple, Stupid!), as most of it boils down to the simple formula that I discussed above. That’s it.
If interest rates go up, and prices go down, what happens to the price of a security? We know that interest rates are going up[3], so when looking at a business, what will happen to its cash flow? Look for the businesses that maintain their cash flow, and you have your high-quality business. Keep it simple, stupid.
The best part is that their share price may go down during this period (perfectly normal), which means that you have the opportunity to buy these high-quality business at a discounted price. This isn’t some hidden financial secret or the inside scoop that you’ve been searching for. It’s actually the well-documented advice of one of history’s greatest investors, Warren Buffet.
It may also help explain why high inflation and interest rates do not affect great businesses as much as people typically expect!
So if you’re looking to grow your personal wealth and keep it simple without the stupid, get in touch with us here at Julius Wealth Advisors today!
References:
Food prices soar to 40-year highs, pinching shoppers at groceries and restaurants - NBC.com
Present Value (PV)- Investopedia.com
The Fed delivers biggest interest rate hike in decades to combat surging inflation - NPR.org
Disclosures:
This piece contains general information that is not suitable for everyone and was prepared for informational purposes only. Nothing contained herein should be construed as a solicitation to buy or sell any security or as an offer to provide investment advice. The information contained herein has been obtained from sources believed to be reliable, but the accuracy of the information cannot be guaranteed. Past performance does not guarantee any future results. The information in this material is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation. For additional information about Julius Wealth Advisors, including its services and fees, contact us or visit adviserinfo.sec.gov.