- When inflation is high, value stocks perform better, and when inflation is low, growth stocks perform better.
What is the impact of growing inflation on the stock market?
Read: Traders lift bets on a half-point Fed rate hike in March to as high as 83 percent due to ‘blowout’ inflation in the United States.
The data, on the other hand, does not lie. Consider what I discovered after examining the pattern of the 10-year Treasury yield TNX,+3.95 percent TMUBMUSD10Y,2.417 percent prior to the 17 bear markets identified in Ned Davis Research’s bear-and-bull-market calendar since 1962. (I started there since it was the first year for which the US Treasury had historical data for the 10-year Treasury.) In ten of the 17 bear markets, the 10-year yield was lower on the day the bear market started than it had been three months before.
In the current situation, however, interest rates have risen significantly: the 10-year yield is now 2.01%, up from 1.56 percent three months ago.
I repeat that these findings do not imply that we are not in the early stages of a new bear market. After all, seven of the last 17 bear markets began at a period when the 10-year yield had climbed in the preceding three months, just as it is today. It’s plausible that a bear market started in early January, when the S&P 500 index SPX,+0.07% reached its all-time high. It is currently roughly 4% lower than its previous peak.
The correct conclusion is that interest-rate trends are a poor predictor of when bear markets will start. As a result, even if interest rates magically fell in the coming months, bulls shouldn’t expect to breathe a sigh of relief.
Many of you are astonished by my findings because you are suffering from “money illusion” or “inflation illusion,” as economists term it. I went into greater detail about these illusions earlier this month, but in a nutshell, they develop when you try to compare a nominal rate (one that hasn’t been adjusted for inflation) with a real rate (adjusted by inflation).
As a result, when inflation and interest rates rise, investors will update their stock market valuations inaccurately. They will, very appropriately, discount future years’ earnings at a higher rate, lowering the present value of those future earnings. However, that is only half of the story. They are oblivious to the fact that when inflation is strong, future wages grow quicker than they would otherwise.
These two effects of increasing inflation and interest rates cancel each other out to some extent. Although nominal earnings will be larger, they will need to be discounted at a higher rate to return to current value. The second of these two outcomes is recognized by inflation and money illusion, but not the first.
Do stocks rise in response to rising inflation?
Consumers, stocks, and the economy may all suffer as a result of rising inflation. When inflation is high, value stocks perform better, and when inflation is low, growth stocks perform better. When inflation is high, stocks become more volatile.
Where should I place my money to account for inflation?
“While cash isn’t a growth asset, it will typically stay up with inflation in nominal terms if inflation is accompanied by rising short-term interest rates,” she continues.
CFP and founder of Dare to Dream Financial Planning Anna N’Jie-Konte agrees. With the epidemic demonstrating how volatile the economy can be, N’Jie-Konte advises maintaining some money in a high-yield savings account, money market account, or CD at all times.
“Having too much wealth is an underappreciated risk to one’s financial well-being,” she adds. N’Jie-Konte advises single-income households to lay up six to nine months of cash, and two-income households to set aside six months of cash.
Lassus recommends that you keep your short-term CDs until we have a better idea of what longer-term inflation might look like.
How do you protect yourself from inflation?
If rising inflation persists, it will almost certainly lead to higher interest rates, therefore investors should think about how to effectively position their portfolios if this happens. Despite enormous budget deficits and cheap interest rates, the economy spent much of the 2010s without high sustained inflation.
If you expect inflation to continue, it may be a good time to borrow, as long as you can avoid being directly exposed to it. What is the explanation for this? You’re effectively repaying your loan with cheaper dollars in the future if you borrow at a fixed interest rate. It gets even better if you use certain types of debt to invest in assets like real estate that are anticipated to appreciate over time.
Here are some of the best inflation hedges you may use to reduce the impact of inflation.
TIPS
TIPS, or Treasury inflation-protected securities, are a good strategy to preserve your government bond investment if inflation is expected to accelerate. TIPS are U.S. government bonds that are indexed to inflation, which means that if inflation rises (or falls), so will the effective interest rate paid on them.
TIPS bonds are issued in maturities of 5, 10, and 30 years and pay interest every six months. They’re considered one of the safest investments in the world because they’re backed by the US federal government (just like other government debt).
Floating-rate bonds
Bonds typically have a fixed payment for the duration of the bond, making them vulnerable to inflation on the broad side. A floating rate bond, on the other hand, can help to reduce this effect by increasing the dividend in response to increases in interest rates induced by rising inflation.
ETFs or mutual funds, which often possess a diverse range of such bonds, are one way to purchase them. You’ll gain some diversity in addition to inflation protection, which means your portfolio may benefit from lower risk.
Who is the hardest hit by inflation?
Inflation is defined as a steady increase in the price level. Inflation means that money loses its purchasing power and can buy fewer products than before.
- Inflation will assist people with huge debts, making it simpler to repay their debts as prices rise.
Losers from inflation
Savers. Historically, savers have lost money due to inflation. When prices rise, money loses its worth, and savings lose their true value. People who had saved their entire lives, for example, could have the value of their savings wiped out during periods of hyperinflation since their savings became effectively useless at higher prices.
Inflation and Savings
This graph depicts a US Dollar’s purchasing power. The worth of a dollar decreases during periods of increased inflation, such as 1945-46 and the mid-1970s. Between 1940 and 1982, the value of one dollar plummeted by 85 percent, from 700 to 100.
- If a saver can earn an interest rate higher than the rate of inflation, they will be protected against inflation. If, for example, inflation is 5% and banks offer a 7% interest rate, those who save in a bank will nevertheless see a real increase in the value of their funds.
If we have both high inflation and low interest rates, savers are far more likely to lose money. In the aftermath of the 2008 credit crisis, for example, inflation soared to 5% (owing to cost-push reasons), while interest rates were slashed to 0.5 percent. As a result, savers lost money at this time.
Workers with fixed-wage contracts are another group that could be harmed by inflation. Assume that workers’ wages are frozen and that inflation is 5%. It means their salaries will buy 5% less at the end of the year than they did at the beginning.
CPI inflation was higher than nominal wage increases from 2008 to 2014, resulting in a real wage drop.
Despite the fact that inflation was modest (by UK historical norms), many workers saw their real pay decline.
- Workers in non-unionized jobs may be particularly harmed by inflation since they have less negotiating leverage to seek higher nominal salaries to keep up with growing inflation.
- Those who are close to poverty will be harmed the most during this era of negative real wages. Higher-income people will be able to absorb a drop in real wages. Even a small increase in pricing might make purchasing products and services more challenging. Food banks were used more frequently in the UK from 2009 to 2017.
- Inflation in the UK was over 20% in the 1970s, yet salaries climbed to keep up with growing inflation, thus workers continued to see real wage increases. In fact, in the 1970s, growing salaries were a source of inflation.
Inflationary pressures may prompt the government or central bank to raise interest rates. A higher borrowing rate will result as a result of this. As a result, homeowners with variable mortgage rates may notice considerable increases in their monthly payments.
The UK underwent an economic boom in the late 1980s, with high growth but close to 10% inflation; as a result of the overheating economy, the government hiked interest rates. This resulted in a sharp increase in mortgage rates, which was generally unanticipated. Many homeowners were unable to afford increasing mortgage payments and hence defaulted on their obligations.
Indirectly, rising inflation in the 1980s increased mortgage payments, causing many people to lose their homes.
- Higher inflation, on the other hand, does not always imply higher interest rates. There was cost-push inflation following the 2008 recession, but the Bank of England did not raise interest rates (they felt inflation would be temporary). As a result, mortgage holders witnessed lower variable rates and lower mortgage payments as a percentage of income.
Inflation that is both high and fluctuating generates anxiety for consumers, banks, and businesses. There is a reluctance to invest, which could result in poorer economic growth and fewer job opportunities. As a result, increased inflation is linked to a decline in economic prospects over time.
If UK inflation is higher than that of our competitors, UK goods would become less competitive, and exporters will see a drop in demand and find it difficult to sell their products.
Winners from inflation
Inflationary pressures might make it easier to repay outstanding debt. Businesses will be able to raise consumer prices and utilize the additional cash to pay off debts.
- However, if a bank borrowed money from a bank at a variable mortgage rate. If inflation rises and the bank raises interest rates, the cost of debt repayments will climb.
Inflation can make it easier for the government to pay off its debt in real terms (public debt as a percent of GDP)
This is especially true if inflation exceeds expectations. Because markets predicted low inflation in the 1960s, the government was able to sell government bonds at cheap interest rates. Inflation was higher than projected in the 1970s and higher than the yield on a government bond. As a result, bondholders experienced a decrease in the real value of their bonds, while the government saw a reduction in the real value of its debt.
In the 1970s, unexpected inflation (due to an oil price shock) aided in the reduction of government debt burdens in a number of countries, including the United States.
The nominal value of government debt increased between 1945 and 1991, although inflation and economic growth caused the national debt to shrink as a percentage of GDP.
Those with savings may notice a quick drop in the real worth of their savings during a period of hyperinflation. Those who own actual assets, on the other hand, are usually safe. Land, factories, and machines, for example, will keep their value.
During instances of hyperinflation, demand for assets such as gold and silver often increases. Because gold cannot be printed, it cannot be subjected to the same inflationary forces as paper money.
However, it is important to remember that purchasing gold during a period of inflation does not ensure an increase in real value. This is due to the fact that the price of gold is susceptible to speculative pressures. The price of gold, for example, peaked in 1980 and then plummeted.
Holding gold, on the other hand, is a method to secure genuine wealth in a way that money cannot.
Bank profit margins tend to expand during periods of negative real interest rates. Lending rates are greater than saving rates, with base rates near zero and very low savings rates.
Anecdotal evidence
Germany’s inflation rate reached astronomical levels between 1922 and 1924, making it a good illustration of high inflation.
Middle-class workers who had put a lifetime’s earnings into their pension fund discovered that it was useless in 1924. One middle-class clerk cashed his retirement fund and used money to buy a cup of coffee after working for 40 years.
Fear, uncertainty, and bewilderment arose as a result of the hyperinflation. People reacted by attempting to purchase anything physical such as buttons or cloth that might carry more worth than money.
However, not everyone was affected in the same way. Farmers fared handsomely as food prices continued to increase. Due to inflation, which reduced the real worth of debt, businesses that had borrowed huge sums realized that their debts had practically vanished. These companies could take over companies that had gone out of business due to inflationary costs.
Inflation this high can cause enormous resentment since it appears to be an unfair means to allocate wealth from savers to borrowers.
Is inflation beneficial to investors?
Most individuals are aware that inflation raises the cost of their food and depreciates the worth of their money. In reality, inflation impacts every aspect of the economy, and it can eat into your investment returns over time.
What is inflation?
Inflation is the gradual increase in the average cost of goods and services. The Bureau of Labor Statistics, which compiles data to construct the Consumer Price Index, measures it (CPI). The CPI measures the general rise in the price of consumer goods and services by tracking the cost of products such as fuel, food, clothing, and automobiles over time.
The cost of living, as measured by the CPI, increased by 7% in 2021.
1 This translates to a 7% year-over-year increase in prices. This means that a car that costs $20,000 in 2020 will cost $21,400 in 2021.
Inflation is heavily influenced by supply and demand. When demand for a good or service increases, and supply for that same good or service decreases, prices tend to rise. Many factors influence supply and demand on a national and worldwide level, including the cost of commodities and labor, income and goods taxes, and loan availability.
According to Rob Haworth, investment strategy director at U.S. Bank, “we’re currently seeing challenges in the supply chain of various items as a result of pandemic-related economic shutdowns.” This has resulted in pricing imbalances and increased prices. For example, due to a lack of microchips, the supply of new cars has decreased dramatically during the last year. As a result, demand for old cars is increasing. Both new and used car prices have risen as a result of these reasons.
Read a more in-depth study of the present economic environment’s impact on inflation from U.S. Bank investment strategists.
Indicators of rising inflation
There are three factors that can cause inflation, which is commonly referred to as reflation.
- Monetary policies of the Federal Reserve (Fed), including interest rates. The Fed has pledged to maintain interest rates low for the time being. This may encourage low-cost borrowing, resulting in increased economic activity and demand for goods and services.
- Oil prices, in particular, have been rising. Oil demand is intimately linked to economic activity because it is required for the production and transportation of goods. Oil prices have climbed in recent months, owing to increased economic activity and demand, as well as tighter supply. Future oil price rises are anticipated to be moderated as producer supply recovers to meet expanding demand.
- Reduced reliance on imported goods and services is known as regionalization. The pursuit of the lowest-cost manufacturer has been the driving force behind the outsourcing of manufacturing during the last decade. As companies return to the United States, the cost of manufacturing, including commodities and labor, is expected to rise, resulting in inflation.
Future results will be influenced by the economic recovery and rising inflation across asset classes. Investors should think about how it might affect their investment strategies, says Haworth.
How can inflation affect investments?
When inflation rises, assets with fixed, long-term cash flows perform poorly because the purchasing value of those future cash payments decreases over time. Commodities and assets with changeable cash flows, such as property rental income, on the other hand, tend to fare better as inflation rises.
Even if you put your money in a savings account with a low interest rate, inflation can eat away at your savings.
In theory, your earnings should stay up with inflation while you’re working. Inflation reduces your purchasing power when you’re living off your savings, such as in retirement. In order to ensure that you have enough assets to endure throughout your retirement years, you must consider inflation into your retirement funds.
Fixed income instruments, such as bonds, treasuries, and CDs, are typically purchased by investors who want a steady stream of income in the form of interest payments. However, because most fixed income assets have the same interest rate until maturity, the buying power of interest payments decreases as inflation rises. As a result, as inflation rises, bond prices tend to fall.
The fact that most bonds pay fixed interest, or coupon payments, is one explanation. Inflation reduces the present value of a bond’s future fixed cash payments by eroding the buying power of its future (fixed) coupon income. Accelerating inflation is considerably more damaging to longer-term bonds, due to the cumulative effect of decreasing buying power for future cash flows.
Riskier high yield bonds often produce greater earnings, and hence have a larger buffer than their investment grade equivalents when inflation rises, says Haworth.
Stocks have outperformed inflation over the previous 30 years, according to a study conducted by the US Bank Asset Management Group.
2 Revenues and earnings should, in theory, increase at the same rate as inflation. This means your stock’s price should rise in lockstep with consumer and producer goods prices.
In the past 30 years, when inflation has accelerated, U.S. stocks have tended to climb in price, though the association has not been very strong.
Larger corporations have a stronger association with inflation than mid-sized corporations, while mid-sized corporations have a stronger relationship with inflation than smaller corporations. When inflation rose, foreign stocks in developed nations tended to fall in value, while developing market stocks had an even larger negative link.
In somewhat rising inflation conditions, larger U.S. corporate equities may bring some benefit, says Haworth. However, in more robust inflation settings, they are not the most successful investment tool.
According to a study conducted by the US Bank Asset Management Group, real assets such as commodities and real estate have a positive link with inflation.
Commodities have shown to be a dependable approach to hedge against rising inflation in the past. Inflation is calculated by following the prices of goods and services that frequently contain commodities, as well as products that are closely tied to commodities. Oil and other energy-related commodities have a particularly strong link to inflation (see above). When inflation accelerates, industrial and precious metals prices tend to rise as well.
Commodities, on the other hand, have significant disadvantages, argues Haworth. They are more volatile than other asset types, provide no income, and have historically underperformed stocks and bonds over longer periods of time.
As it comes to real estate, when the price of products and services rises, property owners can typically increase rent payments, which can lead to increased profits and investor payouts.
Is inflation beneficial to technology stocks?
High-growth equities have struggled throughout 2021 and this amazing start to 2022, owing to fears that the Fed may raise interest rates to battle inflation, putting pressure on their valuations. Professor Vittorio de Pedys criticizes all three pillars of the mainstream argument in this contribution based on his impact paper.
The Fed is unquestionably behind the curve when it comes to dealing with inflation. The M2 money supply indicator, which increased by 40% from 2019 to 2021, is a clear indicator of price pressure. Today’s supply chain bottlenecks are the outcome of economic limitations being countered with a significant shift in demand for products vs services, rather than a global economy unraveling. Companies are addressing this issue by re-engineering their supply chains and constructing factories (see Intel, Taiwan semiconductors). The IHS Markit PMI indices in emerging markets have all recently increased considerably, indicating that manufacturing capacity is improving. Money’s velocity is decreasing: because to productivity-enhancing technology, businesses are spending money less fast. Prices will continue to fall as a result of this secular trend. Finally, comparisons will be easier: inflation will be recorded in the second quarter of 2022 versus the substantially higher numbers witnessed throughout 2021. In 2022, tougher comps will inevitably hold down headline inflation. Market data backs up this assertion: the 5×5 years forward-forward in Libor/inflation swaps, a leading indication of market expectations, indicates that market dealers estimate inflation to be 2.5 percent in five years.
Fed funds rates will aim 2.5 percent in 2024 under the most extreme scenario. It’s hardly a frightening figure. Given the high quantity of business and student debt and its low quality, if the Fed hikes rates above the inflation peak, it risks halting the economic growth and unleashing a cascade of bankruptcies, resulting in an economic crisis. The cost of government debt servicing might soar, pushing out other, more vital public spending. On the other hand, if the Fed decides to maintain its current policy, its dovish posture will further fuel inflationary expectations. As a result, the inflate or die trap appears to be the best option. A strong US dollar will also assist in the long run. Because the real rate is minus 5.5 percent, the government can sit back and watch its mountain of debt (now at 136 percent of GDP) shrink. When looking at Fed Funds Future deliveries for the end of 2022 on the CBOT, the market is pricing a 0.874 percent O/N rate one year from now with three rate hikes. A similar message can be found in the EuroDollar Futures, with the expected 3-months rate for June 2024 trading at an unimpressive 1.37 percent. Chairman Jerome Powell is no Paul Volcker, so the Fed will put on a hawkish mask to gain time, then back down as inflation starts to fall in the second half of 2022.
According to Vittorio de Pedys, 2022 will be a stronger year than 2021 since rate hikes are beneficial to hypergrowth stocks. It’s the “roaring technological twenties”!
Since their all-time high in March 2021, high-growth technology stocks have been steadily declining. According to this logic, the higher the interest rate, the higher the discount rate employed in valuation models such as DCF and CAPM, and the lower the value of a growth stock. Higher inflation, on the other hand, has not historically sunk markets. Rates that are higher do. To destroy growth stocks, substantially higher rates than those proposed by the Fed will be required. Even if most people are unhappy, the economy is essentially in good shape. SPACs, Reddit investors, “meme” stocks, cryptocurrencies, and IPOs are all showing signs of froth. In terms of rates, the “danger” zone begins at 5%. According to studies, there has never been a recession with a rate of less than 4%. Over any 19-year period, US stocks have outpaced inflation 100% of the time, according to Goldman Sachs. The market is telling us that the Fed raised rates eight times between 2016 and 2018, and that growth companies prospered throughout that time: just look at Cathie Wood’s flagship ARK Innovation ETF (ARKK), which soared 90 percent during that time. Growth stocks are damaged by the worry of rising interest rates: the pain is limited to the prospect of higher rates. Once this occurs, these equities benefit because their greater growth potential is accurately valued above a minor multiple compression due to somewhat higher discount rates. The adoption of technology by a larger number of people is unstoppable. Hypergrowth stocks are at the heart of these factors, and they will gain from a strengthening economy.