Chances are, with so many dramatic developments in financial markets over the past few months, you’ve been hearing a lot about the economy, and it can be confusing. Concepts like inflation and deflation are being discussed, but what do they mean and what is the potential impact regarding your financial plan?
Understanding these economic terms will help you gain a better perspective on what’s happening in financial markets, and why. After all, the world has been experiencing an unprecedented health crisis that is driving a global economic transformation.
In recent times, we have seen central banks around the world lower their interest rates to near (or at) zero in an effort to provide support to their economy and help ensure the proper functioning of financial markets. We’ve also seen oil prices decline sharply based on drastically reduced demand for travel. Economic activity has been severely limited as a result of social distancing and stay-in-place measures.
All of these factors – among others – have disrupted financial markets and created extreme volatility. It helps to know how different economic environments arise and how their effect on the performance of your investments could impact your financial goals.
Three key economic terms
- Inflation. This is one of the more common terms you’ll encounter. When an economy is strong, and activity is robust, the prices of goods and services tend to rise. At moderate levels, inflation indicates a healthy, growing economy. However, if inflation jumps too high, prices surge accordingly, and this will reduce the purchasing power of individuals, businesses and governments alike. If consumers cannot buy as much, company profitability decreases, the economy slows, and financial markets will generally decline in step. That’s why central banks watch inflation rates closely. If the economy appears to be gaining too much strength, they will raise interest rates to help control economic activity and keep inflation at a reasonable level.
- Deflation. Deflation is the opposite of inflation and signifies dropping prices for goods and services. In this environment, purchasing power increases as you can buy more for a given amount of money than you can when prices are rising or holding steady. Deflation is a consequence of an imbalance between supply and demand. When supply significantly outpaces demand, prices will drop to help encourage greater demand. Commodities like oil and gold tend to favour an inflationary environment, so deflation will drag down the prices of most commodities and the securities of commodity-related businesses.
- Reflation. Usually, when inflation has been low for some period, the trend starts shifting again to growth and the economy is said to be reflating. During times of reflation, the job market heats up along with growing demand, and wages rise as a result. This will push companies to begin increasing prices for their goods and services to offset rising wages, which eventually leads to an inflationary environment. This period of economic growth is typically good for stock markets, as companies make gains from increased business. On the heels of a worldwide shutdown where economic activity stalled and interest rates remain at historically low levels to help support and stimulate economic growth, the global economy may be in – or approaching – reflationary mode.
The importance of diversification
As your Financial Advisor, I keep on top of what’s going on in the economy so I can understand how your portfolio may be affected. Since economic conditions change and can be unpredictable, it’s valuable to have an investment portfolio that is sufficiently diversified to withstand different environments, while still appropriate for your particular risk tolerance, time horizon and financial objectives.
To learn more about how your portfolio is keeping you on track to meet your long-term goals, contact our office today.