Which is scarier? Inflation or investing in volatile markets?

Market volatility has shot up and whispers of pending recession are spreading. A worrisome place to be in for investors. Inflation is at the heart of the problem with higher commodities prices and a "hot" economy in the US driving the Fed to tighten policy.

The normal solution to combat inflation is to invest.

But in today's context, which is scarier? Inflation or investing in volatile markets? Let’s take a look…

“The normal solution to combat inflation is to invest. 

But in today's context, which is scarier - inflation or investing in volatile markets”        

Inflation impacts the purchasing power of cash, meaning it buys less today than before.

To illustrate, the chart below shows how $100 in 1998 is equivalent to less than $50 today. You can also see from the bars at the bottom how annual inflation chips away at the value of cash – with our $100 having less than half of its original purchasing power after just two decades.

Source: Refinitiv Datastream; HSBC Calculations; World Bank Global Inflation % Annual from 1999

So does this mean inflation is a bad thing? Not necessarily. In theory, your take-home pay should rise in-line with inflation, but this rarely happens in practice.

And very high inflation means the purchasing power of your cash is substantially eroded every year. In extreme situations, people struggle to afford everyday necessities as prices go up. What is more, currencies become unstable and can potentially collapse.

It should be said that very low inflation or deflation – when prices actually decline – is also damaging because people don’t want to spend money on goods and services. Why rush when things will cost the same or even less next month? This is bad for an economy because growth slows, which hurts employment and wages. Japan suffered this fate for years.

Therefore, central banks try to achieve a so-called ‘Goldilocks’ scenario for inflation: not too hot, not too cold. The US Federal Reserve, for example, believes the ‘just right’ level is an annual rise in prices of 2%. Inflation at such rates are not to be feared as part of a well-functioning economy.

This is why the Fed is so determined to tighten policy to bring inflation down. And consequently why markets are so worried that an over-aggressive tightening of policy may lead to recession.

Running the hamster wheel of inflation

In order to preserve the purchasing power of money, your returns need to at least match inflation rates around the world.

This is a problem with interest rates at or near historic lows today. The chart below shows that inflation is more than double corresponding government bond yields (10-year) in the many parts of the developed world. And this is conservative. Many bank accounts are paying far less than the country’s 10-year bond.?

So people in those countries are losing purchasing power on their deposits. In the US, for example, cash is currently being eroded via inflation by more than 8% annually, while Americans can conceivably earn no more than 3% in interest.

?Source: Refinitiv Datastream; Inflation CPI 12 Month YoY; 10 Year Bond Yield; Data as of 11 May 22

Investing could be the answer...

If we look through history and how the stock market has performed, it’s clear to see the stock market has been an effective way to combat inflation. The chart below shows over the past 20 years, global share prices have more than made up the erosion of purchasing power.

Source: Refinitiv Datastream; HSBC Calculations; World Bank Global Inflation % Annual from 1999; Global Equities; MSCI World Index

But it's scary right now.

Like most things in life, there’s always a trade-off. Investing in the stock market means tolerating volatility where the value of one’s investment could fall substantially. We saw this at the beginning of Covid-19 and during the global financial crisis in 2008. Of course in both examples, stocks recovered significantly to new highs.?

The good news is, stocks are cheaper today than they were 6 months ago. Some of the volatility has already been weathered.

There are also ways to manage volatility and sell-offs. Granted that government bonds have sold off (bond yields now significantly higher than dividends on the stock market) together with stocks recently. But with yields now higher, there's an argument that the case is stronger to adding them as a defensive measure in portfolios.

Multi-asset portfolios are still a good way to reduce risk over the medium-long term, giving investors a smoother ride and less stress. The grey line below tracks the performance of a portfolio comprising 60% stocks and 40% government bonds (which are much less volatile than stocks). You can see it has offered a similar return to just stocks over the past 30 years – but with much less volatility.?

Source: Refinitiv Datastream; HSBC Calculations; MSCI World Index; 60/40 Portfolio constructed using 60% MSCI World; 40% FTSE World Government Bond Index

This is a simple illustration and the practical realities of building, maintaining and monitoring a diverse range of assets is more complex. The easiest way is to invest in a multi-asset fund that offers a nimble and diversified portfolio. Also, in the short-term, there may be short periods (such as now) where both bonds and equities underperform.?

For me, this is a reminder that investing needs to be thought of as a medium-to-long term endeavour.?

So which is scarier? Inflation or financial markets?

Whether one should invest is subjective. Financial markets can be scary but there are clear ways to manage this. The trick is to maintain a disciplined approach balanced across different asset classes, geographies and sectors. For example, in the current environment, you really want to be allocated to investments that benefit from inflation (e.g. Energy, financials sectors) and are more resilient to volatility (e.g. Healthcare, consumer staples).?

It is also important not to panic out of your investments when markets fall, thus missing the significant rebounds that are crucial to generating long-run returns.

Inflation however is a constant, eating away at your savings bit by bit, meaning you can buy less with your money every passing year.

For me, inflation is the one I’m more scared of.

What about you?