Why inflation matters to
investors

The not-so-silent killer

Let’s start with one of the well-known inflation charts, showing how inflation eats away capital over time. The chart below shows the declining (real) value of EUR 10,000 in cash over time for four different inflation scenarios, ranging from 1% to 4%.

For example, if you keep that EUR 10K under your mattress for ten years (120 months), with a constant inflation level of 2.0% – the target of many central banks around the globe – its real value will decline to EUR 8,189. That’s a ‘loss’ of over 18%. If we move to an environment of structurally higher inflation, for example, 3%, the loss grows to 26%. Inflation is often called the silent killer, but based on the data above, it isn’t really that silent. Doing nothing with your money will cost you big time.

Why people invest

Inflation is a key and straightforward reason people invest (and save.) They want to stay ahead of inflation to preserve purchasing power. So, what do they invest in? Nearly all investment portfolios contain at least some equities and bonds. This is unsurprising, as these asset classes represent more than 80%(!) of the total investable universe and represent the two common ways for companies and governments to attract capital (equity and debt). But equally important, they have rewarded investors over time by beating inflation. The chart below shows the cumulate return on US Equities (S&P 500 Index) and US Treasuries going back to 1973 (when US Treasury data became available) against US headline inflation. As you can tell, even when the high inflation environment of the late 1970s and early 1980s is included, equities and bonds beat inflation in the long run. The same is true for Equities and Treasuries outside the US.

Inflation Sensitivity

However, the fact that Equities and Treasuries beat inflation over time does not mean they are insensitive to changes in inflation. Quite the contrary. As it turns out, the level of inflation has a big impact on future returns.

At this stage, it’s important to recognize that there are many ways to reflect a relationship between market returns and inflation. For example, the chart below is commonly used by ‘experts’ to show that equities returns are high when annual inflation is low and low or negative when annual inflation is high.

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