Economy

When inflation threatens your finances

Riding the trough: The best way to moderate inflation risk is to invest in inflation-based products.  

Even as COVID-19 continues to be a cause for concern, many fear a rise in inflation because of supply-side constraints owing to lockdowns in various parts of the country. In this article, we discuss whether you can moderate the effects of inflation on your personal finance.

Inflation risk

Inflation has a direct impact on your living expenses because you have to spend more to maintain your current standard of living. It is moot if your income would increase given the current state of the economy. Even if your income does increase, it is unlikely to keep pace with inflation. Now, increased spending without corresponding increase in income would mean lower savings to meet life goals.

Then, there is the secondary effect on your life goals. You may be investing to accumulate money to buy a house, fund your child’s college education or save for your retirement. All these goals are exposed to inflation risk.

The house you want to buy may be worth ₹2 crore today. Assuming a housing inflation of 10% per annum over the next five years, the house, five years hence, would cost ₹3.22 crore. Let us suppose you plan to save ₹64 lakh (20% of ₹3.22 crore) over the next five years for down payment and intend to borrow the rest from the bank.

In addition to the possibility that your investment may not earn the required return, your risk is that actual housing inflation could be greater than 10%. So, even if you accumulate ₹64 lakh in five years, you may fall short of offering the 20% down payment as housing would now be costlier. Inflation risk affects everyone whether you are a working executive or a retiree.

Inflation-based products

The best way to moderate inflation risk is to invest in inflation-based products.

Some products provide returns to protect your purchasing power.

For instance, in U.S., there are Treasury Inflation Protection Securities (TIPS). Similar retail products are yet to be available in India.

Other inflation-based products generate positive returns when inflation rises. Managed futures in the U.S., for instance. In the absence of such products in India, you have to directly trade in commodity futures such as crude, copper and zinc, which many already do. What if you are uncomfortable with trading in commodity derivatives?

A less-preferred alternative is to trade in momentum stocks. Momentum stocks are those that have been rising for a while and are expected to continue their uptrend. Such stocks produce positive returns but have the tendency to decline sharply when the market turns.

The argument is that you can capture handsome returns on these stocks in quick time. The additional cash flows from such investments can moderate the stress you could face because of rising inflation, but the associated investment risks are high.

Alternatively, you should consider buying shares of commodity-based producers and financial services companies. Commodity producers ought to do well when the commodity prices increase (which increases inflation).

Likewise, rising inflation could push interest rates, making the financial sector appear attractive. The caveat is that better earnings prospects for companies may not necessarily translate into higher stock prices.

Conclusion

Rising inflation (inflation risk) is an issue for working executives. Fortunately, retirees and those approaching retirement can moderate inflation risk by investing in income-generating real estate.

This is because rental income can keep pace with rising inflation. New properties fetch market rentals and, therefore, move more closely with inflation than older properties. Real estate is sub-optimal for working executives as such investments are lumpy and illiquid.

Inflation’s saving grace? The value of your existing borrowings will fall as money will be worth less than when you borrowed. Hardly comforting when living expenses are increasing, you might say.

(The writer offers training programmes for individuals for managing their personal investments)


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Printable version | Aug 1, 2021 5:05:54 PM | https://www.thehindu.com/business/Economy/when-inflation-threatens-your-finances/article34862042.ece

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