The Connection between Inflation and Interest Rate Expectations
In terms of your investment portfolio, we often cannot talk about investments without also discussing inflation and interest rate expectations. Inflation is worrisome for some investors because it has the potential to erode the purchasing power of their original investment. In reality, it impacts some asset classes more than others.
What are asset classes?
Simply put, asset classes are types of investments grouped together. There are three main asset classes most financial advisors agree on:
- Equities: these are stocks
- Fixed-income: these are commonly known as bonds
- Cash: this is the money you have in savings, or just in your wallet.
Occasionally, owning property and commodities are also considered asset classes on their own.
How do we measure inflation?
There are two general measures used to track inflation. One is the Producer Price Index (PPI), while the other is the Consumer Price Index (CPI).
Which asset class is most affected by inflation?
Generally, bonds or fixed income are most affected by inflation. The reason for this is because while a bond’s price can fluctuate, so can its yield. The important thing to remember here is that the two factors move in opposite directions: When a bond’s price goes up, its yield goes down, and vice versa. If interest rates rise, the bond’s price falls and the yield rises. Conversely, if interest rates fall, then the bond’s price rises, and the yield falls.
If you’re investing in the stock market, generally, inflation won’t affect your portfolio that much. This is because stocks historically deliver decent returns when adjusted for inflation.
Overall, you want to make sure your portfolio is diversified with stocks, bonds and cash options, especially if you’re headed toward a fixed-income scenario (such as retirement). Talk to a Chatterton & Associates advisor about which financial goals are most important to you. If you have any questions regarding how inflation and interest rate expectations will affect your portfolio, contact us today.
The Team at Chatterton & Associates