What is inflation? Well, we can define it in simple terms as rising prices on goods and services across an economy over a period of time.
Inflation isn’t necessarily all that bad; central banks typically like to see inflation around 2%, which is a steady rise and indicates a healthy economy. Companies are producing, we see consumers buying, wages, employment and business are all up and in general, this is all good news.
However, when inflation does get significantly higher than 2%, it is a worry for investors. A significant rise in prices and goods will reduce the purchasing power of consumers. For example, if you have £1000 in your bank account but inflation is running at 8%. Effectively that £1000 can’t get you the same amount of goods anymore. With inflation, you are effectively losing money. You have probably noticed how things get more expensive over time, and for the most part, we can put that down to inflation.
So who are the typical winners and losers during high inflationary periods? The losers column includes savers as we have just mentioned. Exporters can struggle too as they become less competitive. For example, let’s say that UK Inflation is higher than in other countries, goods will become less competitive and exporters will see a decline in demand and therefore struggle to sell their goods. Also, borrowers on variable rates will struggle as well as workers on fixed incomes. From a market perspective, the economy in general will struggle as they go through a period of uncertainty. The more uncertain a period, the less confidence people have, and the less they are willing to invest. This can lead to less economic growth and fewer job availabilities for example.
When we talk about the winners, we can start talking about something called hedging. In periods where investors suspect inflation is going to be on the rise, what area might they choose to invest their money in? What assets typically perform well?
Gold has long been considered a good hedge, certain commodities too, real estate investment trusts and of course some stocks that are related to the aforementioned.
It’s worth pointing out, that there will be times in the market where we have high inflation but Gold doesn’t perform that well. Equally, there will be times when the other assets just mentioned also struggle despite tending to fare well as a hedge against inflation historically.
So it is important for us to remember that assets will perform better or worse during inflation depending on the circumstances. If you are a super long-term investor, then it might not bother you too much if your holdings struggle over a short period of time. However, if you are someone who is looking to be more active in the markets and therefore more reactive to changes in the macro environment – you might want to have a playbook for each scenario. If inflation is on the rise, find out the reason why, think what markets will struggle to push higher and if you have any exposure to them you can either take them off for a profit, or loss, or stop investing in them.
Equally, you might want to invest in certain markets that will start to perform well. To keep it simple, it could be that you believe inflation is going to be on the rise and you think central banks are going to raise interest rates to keep it under control – so you make the decision to invest in banks in the view that by raising interest rates they will get more return from lending. However, if inflation is out of control, banks will not perform as well as during mildly inflationary environments. If inflation is out of control and people can’t afford what they could before, demand is obviously going to fall and there is a lot of uncertainty and maybe it might make more sense to invest in defensive stocks like consumer discretionary related companies.
We previously mentioned commodities could be a good hedge against inflation. Due to their intrinsic value, commodities are thought of as a hedge against inflation and tend to perform well when consumer goods prices are rising. In contrast, equities tend to perform poorly when high inflation results in increases in interest rates, which tends to reduce the value of future cash flows for businesses due to the effects of inflation.
Research by Vanguard points out that over the last decade, commodities rose by 7% to 9% for every 1% of unexpected inflation experienced by the economy. The low correlation that commodities often have to stocks and bonds may appeal to investors seeking diversification. This reasoning can be strengthened when inflation is on the rise since investors may view commodities as a method to diversify their holdings.
In summary, inflation essentially erodes consumer purchasing power, which in turn hurts earnings and forces a rise in interest rates and bond yields which cuts valuations. This can then lead to a big economic slowdown or even a recession. The question investors ask during this period is ‘how long will it last?’. People often refer to the lost decade of the 1970s when central banks lost control and had little credibility. However, with more tools at their disposal, central banks can try to react quicker to get inflation under control.
Our last bonus lesson focused on investing during a recession. So it might be helpful to refer back to that for what areas of the market perform better or worse. Hopefully, these lessons have helped you map together how an economic cycle can work and how in certain periods what assets may perform better than others.
As always, remember your ‘why’. Have patience if you are a longer-term investor, be diversified and be proactive if something significant changes.
Inflation may sound scary after reading all this but just remember that typically the stock market is higher than inflation. From a US perspective, as we have mentioned previously, the stock market averages a 10% return whereas inflation on average is under 3% a year.
Our next bonus lesson is all about investing in the metaverse. A new and exciting industry with lots to learn about.
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