Inflation is the sustained increase in the prices of goods and services during a given period of time. Supply and demand play an important role in inflation since prices rise when the demand for a good or service increases and the same happens when the supply of a good or service decreases. Supply and demand can be affected by many factors both local and foreign, including the costs of raw materials and labor, taxes on goods and services, indebtedness, etc. Having said that, the main determinant of the rate of inflation is the rate of growth of the money supply.
Inflation is determined through the Consumer Price Index, which tracks the cost of goods such as gasoline, food, clothing, and cars over time to measure the overall increase in the price of goods and services.
When an economy is trapped in an inflationary process, several problems arise for the development of productive activities. From a commercial perspective, there are difficulties in obtaining funds to finance an investment project, and funding is usually obtained at a higher financing rate due to the uncertainty of the future price levels.
On the other hand, savers are going to find themselves involved in difficulties when it comes to allocating their funds and obtaining a positive return in real terms with the aim of not losing purchasing power or losing as little as possible.
Inflation is fundamental from the point of view of financial planning since we must relate our long-term financial objectives to our purchasing power.
How does inflation affect financial markets?
Investors, businesses, and the Fed constantly monitor inflation. The nominal interest rate is a key variable in determining the speed of monetary expansion, while the real interest rate is the nominal interest rate minus the rate of inflation and is often a variable closely tracked by investors.
On the other hand, the Federal Reserve will raise interest rates with the aim of appeasing inflation and its effects on the economy. Raising interest rates increases the cost of borrowing money, so consumers and businesses are discouraged from spending or borrowing money.
The increase in inflation rates has a greater impact on fixed income assets since they are inversely linked to both current and future increases in interest rates, causing the price of bonds in the market to fall.
For those seeking to avoid the direct impact of inflation through fixed-income investments, inflation-indexed bonds can be a good alternative, since the official inflation index of the issuing country is added to its yield.
On the other hand, when it comes to the stock market, inflation does not always have a negative impact.
How does inflation affect stocks?
As we have seen in recent years, a sudden increase in inflation can generate volatility in the market. Stock market performance and share prices are based primarily on expectations of future earnings of companies and their growth. When there is inflation and the value of future earnings is distorted, it can make it difficult for the market to calculate the current value of the companies that make up the market indices.
In addition, higher prices for goods and labor can affect earnings as companies adjust accordingly. As a result, stock prices can fluctuate and cause the previously mentioned volatility.
For investors, stocks can act as a hedge against long-term inflation. Over time, stock prices tend to keep pace with inflation better than bonds because their earnings can adjust upwards, causing stock prices to rise, due to greater pricing power of the company.
For example, if inflation is due to higher input costs, once firms have had enough time to adjust to inflationary pressures and adjust their own prices, revenues will increase to at least partially cover the increase in costs. As a consequence, the profit rate can potentially return to levels similar to those presented prior to the price increase.
Which stock sectors (industries) perform well during inflation?
Inflation can completely wipe out fixed income returns, but dividend-paying stocks in inflation-resistant sectors like energy, consumer staples, real estate, and basic materials can be a great way for investors to offset the negative impacts of inflation.
Energy stands out as an excellent hedge as electricity prices are linearly correlated to energy prices. Likewise, there is a certain circularity between energy prices and inflation, since these represent a relevant proportion of the index.
Also noteworthy are the companies that invest in properties and whose income comes from leasing these assets (such as shopping malls). These assets provide a partial hedge against inflation through the pass-through of price increases in rental contracts and property prices.
Performance of Values Stocks and Growth Stocks during inflation
Investors often divide stocks into two categories: Value Stocks and Growth Stocks. On one hand, Value Stocks correspond to companies that trade at a lower price in relation to their fundamentals (dividends, profits, sales, etc.). This makes them attractive to investors looking for stable returns and more conservative investments. They are usually shares of mature companies with stable and relatively predictable cash flows in the foreseeable future.
On the other hand, we have Growth stocks, which encompass those companies that are expected to grow at a rate significantly higher than the average growth of the market. These companies generally want to reinvest the profits they accumulate to accelerate short-term growth, so they don’t pay dividends. Investors invest in them with the expectation that in the medium or long term they will grow substantially. Their Cash Flows are expected to be higher in the future than in the present.
Faced with an increase in the inflation rate, greater future unpredictability is generated. Coupled with an expectation of future interest rate increases to tame inflation, investors apply higher discount rates when evaluating their investments. Therefore, those companies whose potential is future (Growth Stocks) will suffer a greater drop in valuation. The Value Stocks will be discounted at the same rate, but since their cash flow is intertemporally balanced, their respective valuations are not impacted in the same proportion.
How does Hyperinflation affect the stock market?
Hyperinflation is an economic condition that causes prices to rise at an extremely high rate (usually over 50% month over month). This condition is usually caused by the almost complete collapse of a country’s economic system, causing its currency to completely depreciate. During hyperinflation, stock prices tend to rise like any other price in the economy.
These price increases will lead to higher sales and profits, which can also increase the dividend the company pays, as well as increase the selling price of the stock, sometimes significantly.
Having said that, the impact of hyperinflation is strongly negative on the economy as a whole and largely on the stock market as well. The impact of the same on each asset depends mainly on the cost structure of each company and its possibility of transferring said increases to its prices.
How does inflation affect volatility in the stock market?
The uncertainty that inflation creates in future earnings and a stock’s price can cause increased market volatility. A highly volatile stock leads to sudden new highs and lows, moving erratically where there are quick rises and dramatic falls. Periods of high volatility logically result in large gains and heavy losses alike.
For long-term investors, stocks may act as a hedge against inflation as they tend to keep pace with inflation over time. For this reason, the transitory volatility that is generated at the time of crisis should not worry those investors with a longer time horizon.
For investors who take a more short-term view, such volatility creates opportunities to buy or short stocks. For example, day traders, work with changes that occur second by second. This is also the case for most algorithmic trading strategies that focus on capturing intraday patterns. Intraday trading strategies benefit from increased volatility.
Best industries to hedge against inflation
Assets with long-term fixed cash flows tend to underperform when inflation rises, as the purchasing power of those future cash flows declines over time. By contrast, commodities and assets with adjustable cash flows tend to do better with rising inflation.
Stocks have held up well against inflation over the past 30 years. In theory, a company’s revenue and profit should increase at a rate similar to that of inflation. This means that its share price should rise along with the general prices of consumer and producer goods. Some investments to consider during inflation are investments in raw materials and shares of producers of raw materials, such as energy, materials, etc; Value stocks, which tend to be more exposed to these sectors; and REIT shares.
Real assets like commodities and real estate tend to have a good performance during inflationary years. Historically, commodities have been a reliable way to position themselves against rising inflation, albeit with some ups and downs in their prices as they are more volatile. Energy-related commodities such as oil have a particularly strong relationship with inflation, and precious and industrial metals also tend to rise when inflation picks up.
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