Investors around the world often face more challenges than simply making investing decisions. Depending on where they are located, they may face adverse economic conditions that could undermine even a well-developed investing strategy. This article seeks to explain some of those negative economic conditions and suggest how investors facing them can adapt their investment strategies.
Inflation refers to the change in the cost of goods and services, everything from food and clothing to housing and medical care. Inflation is not always a bad thing. Higher prices can result from a healthy, growing economy, where companies and consumers are making more money and spending it, driving the cost of goods higher. Central banks in developed economies aim to keep inflation at around 2-3% per year, which is usually not a problem for investors.
Inflation becomes a problem generally when it exceeds the rate of growth in an economy. At that point, inflation is undermining consumers’ purchasing power, meaning their incomes buy less goods and services. When inflation becomes too high, consumers and investors will seek to buy goods and services now, before prices rise further. This extra demand can create a negative cycle, driving prices higher and higher. There are many other causes of high inflation, such as commodity shortages or currency devaluations (which is discussed later). High inflation could generally be considered as a consumer price index increase of between 5-10%, but will vary depending on the rate of growth of the country’s economy. An inflation rate of 7%, while very high by developed economy standards, might not be a problem for an emerging market economy growing at 10-15% per year.
Hyperinflation is when inflation spirals out of control, usually due to severe currency weakness, political upheaval or credit issues, and frequently a combination of all of those. Hyperinflation can see price increases in the hundreds or thousands of per cent per year. One month it costs $5 for a bag of rice; the next month it costs $50.
Investing in High Inflation Periods
For investors, normal inflation is not a problem, and may see asset prices like stocks move higher at a rate similar to the inflation rate. Bond investors typically have the most to lose from inflation, as too high inflation erodes the value of the fixed interest payment (coupon). Inflation that’s too high also typically leads to higher interest rates, which sends bond prices lower, again hurting bond investments.
In the case of chronically high inflation or hyperinflation, which are typically due to domestic national problems, investors have little choice but to invest outside of their home country. Fortunately, investing internationally is more accessible than ever. Investors can access well-known multinational stocks listed on more stable countries’ exchanges. ETFs also offer broad access to diverse investment strategies, and are usually listed on exchanges in more stable economies. For instance, Brazil is currently mired in a serious political and economic environment, which has sent the Brazilian real sharply lower against other major currencies, sparking high inflation. A Brazilian investor would probably be well advised to invest outside of Brazil until economic and political conditions improve, which may take several more years. The same Brazilian investor could still invest in Brazilian companies through ETFs offered on US exchanges, for instance, eliminating the risk of further currency weakness.
Economic Weakness and Recessions
The Great Financial Crisis of 2008-2009 left very few economies unscathed, and some are still dealing with its after-effects. In Europe, for instance, Spain, Ireland, and Portugal were all forced to endure severe economic austerity measures for years, such as budget and benefit cuts, along with recessionary conditions. Greece is still suffering through its own economic nightmare with no end in sight. Dozens of other examples dot the globe. And there are always numerous national economies suffering from economic downturns unrelated to the financial crisis. Ukraine was reasonably stable and prosperous until the Russian intervention, for example.
Once again, due to the specific national circumstances at the root of these countries’ economic troubles, investors are probably best advised to diversify internationally until conditions in their home countries stabilize. Depending on the individual situation, periods of economic weakness can last for years, meaning investors will have time to restructure their investments as conditions at home begin to improve.
Currency Devaluations or Extreme Weakness
In most cases, currency values are determined by markets based on the relative level of interest rates and the economic outlook. However, national currencies can be subject to extreme bouts of weakness, which can lead to high or hyperinflation and severe economic upheaval. Sometimes currency weakness is brought on by a government’s decision to officially devalue the domestic currency relative to other international currencies, as Iceland did in the aftermath of the Great Financial Crisis. In other cases, global markets lose faith in a country’s policies or doubt its creditworthiness and abandon its currency. The Argentinian peso is a good example of the latter. Following its debt default in 2002 the value of the peso, which had been pegged at 1-to-1 against the US dollar, has dropped to 9 pesos to one US dollar.
Currencies of smaller economies are generally more prone to devaluations or bouts of extreme weakness than those of larger, more established economies, such as the US or the Eurozone. Investors in such countries should carefully consider the outlook for their currency as part of their overall investment strategy. To minimize currency risk, investors can also look to diversifying internationally, potentially investing in assets that comprise a basket of major global currencies. For instance, a stock investor could invest in ETFs of a Japanese stock index, a US index and European index, and spread their currency exposure across the Japanese yen, US dollar and the euro.
Diversification is the Key
Experienced investors understand the value of diversification-not putting all your eggs in one basket. Given the range of economic disruptions that can occur, a well-diversified investing strategy across countries and regions, asset classes, and currencies is the best way to ride out periods of difficult economic and investing conditions. Most importantly, difficult economic periods don’t last forever. So stick with a dedicated investing plan whether economic conditions are good or bad.
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