How inflation will affect your stocks and bonds

We believe that the rate of inflation will quicken. This would drive up interest rates. Higher interest rates hurt bonds. Consider investing in shorter-term interest-producing investments. Or buy stocks. Inflation can raise company profits and stock prices.

Long-term bonds drop in price when long-term interest rates go up. The farther out the bond’s maturity date, the more the bond’s price will fall. One major factor that sends interest rates up is inflation. After all, if your interest rate is below the inflation rate, then you’re losing money.

Higher inflation is likely on the way. For one thing, global economic growth is accelerating.

Canada’s GDP is expected to grow by 1.9 per cent in 2017. (GDP, or Gross Domestic Product, is the value of goods and services that an economy produces.) That’s up significantly from GDP growth of 1.2 per cent last year. American GDP growth is expected to accelerate to 2.3 per cent. China and India are expected to grow faster this year. The Euro area will continue to grow, albeit at only 1.7 per cent.

A second factor that’s likely to send up inflation is U.S. President Donald Trump’s insistence that Americans manufacture much more. Well-paid American workers will raise the cost of many products, such as cars.

A third factor that’s likely to raise inflation is international competition. If you want certain goods, you’ll have to outbid increasingly affluent consumers in emerging markets such as China.

A fourth factor that’s likely to raise inflation is demographics. The large baby-boom generation is in retirement or pre-retirement. As they withdraw from the labour market, labour shortages are likely to occur. The smaller generations that follow should find their bargaining power significantly stronger.

Central banks can ruin fun parties

Some see central banks as terrible hosts who ‘take away the punch bowl just as the party gets going’. Indeed, the U.S. central bank is expected to raise its benchmark rate at least two more times in 2017. This would cool the economy to prevent inflation.

Another partial offset to higher potential inflation is faster productivity growth. Producing more with less would tend to keep prices in check. The focus on innovation could accelerate productivity growth.

A third partial offset to higher potential inflation is higher immigration. More younger energetic people in Canada would make it easier to care for a swelling population of retirees.

On balance, we think that inflation will rise. This would hurt bond prices. One solution is to put money into short-term interest-producing investments. That way you could quickly reinvest your money at higher rates. Their prices would fluctuate less.

Some inflation can raise company profits. So stocks may outperform bonds for years to come.

This is an edited version of an article that was originally published for subscribers in the April 7, 2017, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.

The Investment Reporter, MPL Communications Inc.
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