International investors face a number of unique risks like political risk and currency risk. Inflation represents another risk very important to understand since it can have a profound impact on the economy. It is true not only in unstable countries, like Zimbabwe where inflation went as high as 2,600.2% in 2008, but also in developed markets worldwide.
Inflation is often measured using the consumer price index (CPI) indicators, which calculate a currency's purchasing power relative to a diverse basket of consumer goods. The CPI is also divided into sub-indexes and sub-sub-indexes to remove certain outliers, such as energy prices, that may have risen due to other geopolitical factors and may not reflect true inflation.
- Inflation is a financial risk that investors take on when they invest internationally.
- While efforts can be made to increase liquidity during times of crisis, inflation can strongly influence bond prices and equities to a lesser degree.
- Investors can reduce their inflation risk exposure by purchasing tangible assets and inflation-protected securities.
Effects on Bonds
Inflation is perhaps most pronounced in bond prices. These prices tend to have an inverse correlation with inflation, since higher inflation leads to higher expected yields, and higher yields lead to lower bond prices. Moreover, ongoing inflation depletes the value of the maturity (principal) payment, since that currency's value is becoming increasingly diluted.
The effects of inflation on bonds can be seen in the difference between "nominal" and "real" returns. Nominal returns are the actual yields, while real returns represent the inflation-adjusted yields paid by borrowers to lenders. Since inflation compounds over time, these differences can add up to significant sums over time.
For international investors, sovereign debt and related ETFs that hold sovereign debt around the world are susceptible to changes in inflation. It's important for investors to watch CPI figures (or unofficial private reports for those countries without reliable reporting) for signs of increasing inflation since that can represent trouble ahead for bondholders.
Mixed Effect on Equities
Inflation may be a universally bad sign for the bond market, but its impact on equities is far less certain. Excess capital can provide companies with cheap loans, which can spur economic growth and drive higher earnings. But out-of-control inflation can result in troubles for the entire economy, including the end markets targeted by corporations.
Many economists argue that moderate inflation of between 1% and 3% produces strong returns for equities, while periods with 6% of higher inflation have always produced negative real returns for equities. Of course, there are others that argue that no level of inflation raises the return on equity seen in public companies, as it's difficult to show a direct cause and effect.
For international investors, central banks that provide liquidity during times of crisis can help boost equities by promoting economic recovery. But inflation that seems out-of-control could result in lower returns in equities. Again, it's important for investors to watch CPI figures (or unofficial private reports) and measure that against economist expectations.
How to Hedge a Portfolio
Investors can reduce their exposure to inflation risk using a variety of methods. The most popular method to hedge against inflation is by purchasing hard assets like gold. Hard assets include commodities such as energy, precious metals, base and industrial metals, agriculture, alternative energy, and forest products. They are tangible assets that are nonperishable and tend to have intrinsic value. In general, these assets tend to be negatively correlated with both stocks and bonds.
Some developed countries also offer other forms of inflation hedges. For instance, the U.S. Treasury offers Treasury Inflation Protected Securities (TIPS) that are adjusted for inflation based on the official CPI figures. Similarly, inflation-protected government bonds in Europe have also drawn the attention of some investors.
Notably, these inflation-adjusted securities can also serve as an indicator of confidence in a government. For instance, investors concerned about the negative implications of inflationary policies may opt to purchase inflation-protected securities instead of non-protected securities, which would create a growing spread between the two over time—a clear warning sign.