It seems strange to be concerned about inflation during one of the sharpest and most severe economic downturns in our lifetimes.
However, given the Federal Reserve’s massive government spending and monetary policy, it’s something that many are thinking about as a potential risk in the not-too-distant future. The “concern” is that once the virus has been contained, the economy could overheat as a result of pent-up demand and government spending.
My initial take on this is that if we do get inflation as a result of all of this spending, it’s a good thing since it implies we’ve beaten the virus and are back to business as usual (if there is such a thing).
I’m not taking a victory lap here because I certainly didn’t expect inflation to reach nearly 8%. I hadn’t anticipated so many supply chain challenges as a result of high consumer demand.
And that piece wasn’t so much about making a macro call as it was about figuring out why value equities had fallen so far behind growth stocks in the years preceding up to the epidemic.
My conclusion was that more inflation was required for value stocks to outperform once more. Here’s how it looks:
Value has tended to do better during decades with above-average inflation and worse during decades with lower inflation, however this is not a perfect link. This was my original theory for why this happened:
Consider growth stocks in the same way that you would a bond. The purchasing value of your fixed rate income payments is reduced over time by inflation, which is why inflation is such a huge risk for bondholders.
The same can be said for growth stocks’ predicted future revenue or profit growth. Value stocks are likely to have cash flows that are already decreasing and will continue to do so in the future. As a result, higher interest rates should affect value equities less than growth companies, because the higher hurdle rate reduces the value of future growth.
Let’s put this notion to the test now that inflation has been rising for almost a year.
Since the beginning of 2021 through Monday’s closing, the DFA small and large cap value funds1 have outperformed the market and growth stocks:
During this inflationary period, value equities have excelled by a wide margin. So far, everything has gone well.
When inflation is greater, value tends to outperform for international companies as well:
It would be naive to believe that inflation is the only driver driving value or growth equities. Inflation has a part, but nominal growth is typically higher when inflation is high.
And sometimes value outperforms growth because growth values are too far off the mark.
Because I can’t forecast the future path of inflation (and I’m not sure anyone else can either), I’m not smart enough to predict whether value stocks will continue to thrive.
However, this serves as an excellent reminder of the significance of diversifying your portfolio across economic cycles.
Since reading Ray Dalio’s The All Weather Story a few years ago, this chart from the book has stayed with me:
Because we don’t know when or why the economic environment will change, the aim is to combine investments that work under different economic regimes together.
No one predicted a major inflation/economic growth increase in 2019, yet that’s exactly what we’re experiencing right now.
In a long time, we haven’t had to deal with a rising inflation/increasing growth economy.
Value stocks have been behind for some time, but perhaps they just needed the ideal circumstances to shine.
I’m not predicting that value investment will continue to outperform. I honestly have no idea.
I’m not sure how much of the inflation story has already been priced into value and growth equities.
I’m not sure if the Fed will be able to keep inflation under control.
I am aware that building a long-term portfolio necessitates diversity of techniques that may thrive in a variety of market and economic conditions.
1Full disclosure: DFA funds are used in several of my firm’s client portfolios, and I own some of these funds.
Why are value stocks superior in an inflationary environment?
This is unmistakably a statistical relationship. That is, value investment has typically outperformed during periods of high inflation while underperforming during periods of low inflation. Investing, on the other hand, is fraught with risk and uncertainty. The most sensible thing an investor can do is choose a strategy that allows them to achieve the highest potential batting average. The historical relationship between inflation and value investing is, in our opinion, highly convincing when examined through this perspective.
Why does this relationship exist, for example, is a nice question to ask. Is there a sound economic reason to believe that the positive correlation between inflation and value investment will continue in the future? To comprehend the answer to this issue, we must first know that growth investing is the polar opposite of value investing. Growth investment, as the name implies, values firms based on their future earnings rather than their previous or current earnings. In addition, by definition, inflation is the process by which money in the future loses its value in the present. As a result, during periods of high inflation, future profits become less valued, while current earnings grow more valuable. Because “value stocks” are valued based on current earnings, inflationary periods benefit value stocks more than growth stocks, and vice versa. As a result, we may be entering a phase in which value investing trumps growth investing, which would be a significant change from recent years.
Do value stocks provide inflation protection?
You might not think of a house as a smart method to protect yourself against inflation, but if you buy it with a mortgage, it can be a great way to do so. With a long-term mortgage, you may lock in affordable financing for up to three decades at near-historically low rates.
A fixed-rate mortgage allows you to keep the majority of your housing costs in one payment. Property taxes will increase, and other costs will climb, but your monthly housing payment will remain the same. If you’re renting, that’s definitely not the case.
And, of course, owning a home entails the possibility of its value rising over time. Price appreciation is possible if additional money enters the market.
Stocks
Stocks are a solid long-term inflation hedge, even though they may be battered by nervous investors in the near term as their concerns grow. However, not all stocks are equivalent in terms of inflation protection. You’ll want to seek for organizations with pricing power, which means they can raise prices on their clients as their own costs grow.
And if a company’s profits increase over time, so should its stock price. While inflation fears may affect the stock market, the top companies are able to weather the storm thanks to their superior economics.
Gold
When inflation rises or interest rates are extremely low, gold has traditionally been a safe-haven asset for investors. When real interest rates that is, the reported rate of interest minus the inflation rate go below zero, gold tends to do well. During difficult economic times, investors often look to gold as a store of value, and it has served this purpose for a long time.
One effective way to invest in gold is to acquire it through an exchange-traded fund (ETF). This way, you won’t have to own and protect the gold yourself. Plus, ETFs provide you the option of owning actual gold or equities of gold miners, which can provide a bigger return if gold prices rise.
How can I plan for inflation in 2022?
With the consumer price index rising at a rate not seen in over 40 years in 2021, the investing challenge for 2022 is generating meaningful profits in the face of very high inflation. Real estate, commodities, and consumer cyclical equities are all traditional inflation-resistant assets. Others, like as tourism, semiconductors, and infrastructure-related investments, may do well during this inflationary cycle as a result of the pandemic’s special circumstances. Cash, bonds, and growth stocks, on the other hand, look to be less appealing in today’s market.
Do you want to learn more about diversifying your investing portfolio? Contact a financial advisor right away.
What should you do if inflation occurs?
As a result, we sought advice from experts on how consumers should approach investing and saving during this period of rising inflation.
Invest wisely in your company’s retirement plan as well as a brokerage account.
Inflation favours whom?
- Inflation is defined as an increase in the price of goods and services that results in a decrease in the buying power of money.
- Depending on the conditions, inflation might benefit both borrowers and lenders.
- Prices can be directly affected by the money supply; prices may rise as the money supply rises, assuming no change in economic activity.
- Borrowers gain from inflation because they may repay lenders with money that is worth less than it was when they borrowed it.
- When prices rise as a result of inflation, demand for borrowing rises, resulting in higher interest rates, which benefit lenders.
Is inflation a negative factor for value stocks?
Value, and the environment. Stocks are a safe haven. Value companies have an advantage over growth stocks due to persistent inflation and rising interest rates.
Before inflation, what should I buy?
At the very least, you should have a month’s worth of food on hand. Depending on your budget, it could be more or less. (I cannot emphasize enough that it must be food that your family will consume.)
If you need some help getting started, this article will show you how to stock up on three months’ worth of food in a hurry.
Having said that, there are some items that everyone will want to keep on hand in the event of a shortage. Things like:
- During the early days of the Covid-19 epidemic, there were shortages of dry commodities such as pasta, grains, beans, and spices. We’re starting to experience some shortages again as a result of supply concerns and sustained high demand. Now is the time to stock your cupboard with basic necessities. Here are some unique ways to use pasta and rice in your dinners. When you see something you like, buy it.
- Canned goods, such as vegetables, fruits, and meats, are convenient to keep and can be prepared in a variety of ways. Individual components take more effort to prepare, but also extend meal alternatives, which is why knowing how to cook from scratch is so important. Processed foods are more expensive and have fewer options. However, if that’s all your family eats, go ahead and stock up! Be aware that processed foods are in low supply at the moment, so basic components may be cheaper and easier to come by.
- Seeds
- Growing your own food is a great way to guarantee you have enough to eat. Gardening takes planning, effort, and hard work, but there’s nothing more delicious or rewarding than eating something you’ve grown yourself. If you’re thinking of starting a garden this year, get your seeds now to avoid the spring rush. To get started, look for videos, books, or local classes to assist you learn about gardening. These suggestions from an expert gardener will also be beneficial.
Buy Extra of the Items You Use Everyday
You may also want to stock up on over-the-counter medicines, vitamin supplements, and immune boosters in case another Covid outbreak occurs. Shortages of pain relievers and flu drugs continue to occur at the onset of each covid wave, which is both predictable and inconvenient.
What is the most common inflation hedge?
When the dollar loses value due to inflation, gold, for example, tends to become more expensive. As a result, an owner of gold is protected (or hedged) against a declining dollar since, as inflation rises and the value of the currency erodes, the cost of each ounce of gold in dollars rises. As a result, the investor gets compensated for the inflation by receiving more dollars per ounce of gold.