Inflation is a sustained period of rising prices for goods and services. It’s been a highly debated phenomenon in economics and finance. On the one hand, moderately rising prices are necessary to drive healthy consumption and economic growth. In developed economies, central banks, such as the US Federal Reserve, Bank of England and European Central Bank, aim for an annual inflation rate of around 2%.
Uncontrollable inflation spikes can reduce the value of money, make savings less secure and create economic uncertainty, which curtails the ability to plan, invest, grow and engage in longer-term contracts.
This is bad news for company stocks. On the chart below we can see the relationship between the price of the US equity index the Dow Jones Industrial Average and the country’s rate of inflation. In 2008, for example, a sharp spike in inflation to 5.6% amid the subprime mortgage crisis that sparked the Great Recession was soon followed by a 48.54% fall in the index. In 2011, a price growth jump to 3.8% led to the index dropping 12.75%.
A similar relationship can be observed between the UK’s rate of inflation and the country’s benchmark index, the FTSE 100. In 2008, shortly after an inflation spike in September, the index had lost 32.05% by February 2009. Similarly, an inflation jump in 2011 can be linked to the index falling 15.51%.
In the current economic climate, inflationary pressure cannot be more relevant. In the US, the world’s biggest economy, inflation soared to 5.4% in both May and June, the highest level in 13 years. In the UK, the inflation rate jumped to a three-year high of 2.5% in June, slowing to 2% in July. The central banks believe the spike to be short-lived as it’s mostly fuelled by rising energy prices and a low base effect from last year when the pandemic hit the economy.
Despite the perceived “transitory” nature of the current spike, investors would do well to remember that if you want peace, you should prepare for war. Fortunately, there are assets and stocks that protect against inflation.
A recently published research paper, The Best Strategies for Inflationary Times, looked at historical returns over the past 95 years of different US equity sectors when the country’s headline inflation figure moved above 5%. Its findings revealed that across all sectors only energy stocks showed positive annualised real returns.
It appears that energy-linked companies that focus on the exploration and production of oil, gas, and renewable energy sources can be seen as the optimal stocks to hedge against inflation according to the report.
The reason these companies benefit from inflationary spikes is that rising commodity prices, including the cost of energy, is what often drives inflation, according to Laith Khalaf, head of investment analysis at AJ Bell. Similarly, mining stocks that extract raw materials from the ground, could benefit from inflation as they have high exposure to the price of commodities.
When traded individually, all commodities showed positive returns under inflationary pressure, averaging an annualised 14%. This contrasts with normal periods when commodity returns are in single digits.
Among commodity groups, energy led returns by a significant margin of 41%, followed by the strong performance in precious and industrial metals, with returns of 11% and 19% respectively.
Bank stocks during inflation
Banks could be another type of stocks to buy during inflation. An unexpected spike introduces the possibility of an interest rate hike. Central banks are likely to respond to inflationary pressures by tightening monetary policy in an effort to control price growth.
That’s good news for banks and lenders as higher interest rates mean borrowing is more expensive, resulting in higher profits from lending margins. In theory, banks should benefit from an inflationary environment.
Yet, according to Khalaf, there are more competing factors at play, as bank stocks are plugged into the economy and an inflationary shock changes the economic dynamics.
The research paper mentioned above also showed that from a historical perspective, financial stocks performance was weak during inflationary spikes as default risks overshadowed the possibility of monetary tightening.
Value stocks during inflation
Inflation is changing the value of money, which directly affects companies’ future earnings. Growth stocks with high valuation metrics, such as price-to-earnings ratio, are particularly vulnerable to inflation spikes because shares price in the expectation of future profits.
Shortly after an inflationary shock, there may be an overall sentiment shift towards value stocks, according to Khalaf. “In the immediate term you’d expect a shift towards value as roaring inflation would knock the growth areas where there aren’t many earnings to speak of at the moment,” he said.
Stocks with high pricing power
As rising prices mean the cost of raw materials used by companies to produce goods grow, the big risk for businesses during an inflationary shock is shrinking profit margins. The key question here is to what extent can a company pass increased costs to their consumers and try to mitigate an inflationary spike.
In a note to clients published in July, UBS said that companies with higher pricing power would do better during an inflationary environment as they would be able to raise prices of their products or services without losing revenues.
To identify companies with a high pricing power investors should search for firms with a dominant market position, high-quality products that cannot be easily substituted and tend to enjoy relatively more stable profit margins, according to UBS.
Non-traditional investments that do well during inflation
The research paper identified some other less conventional assets that tend to perform well during an inflationary shock. Collectibles is one of them, which can include pieces of art, rare wine bottles and stamps –items for which the value is expected to grow in the future.
Collectibles are unlikely to be in a traditional institutional portfolio because they are traded in small volumes and are heavily illiquid. The global wine market turnover, for example, amounted to $364bn in 2019, according to Fortune Business Insights, and is projected to reach $445 by 2027. In comparison, the estimated global equity market turnover was $61tn in 2019, according to the data from World Bank. That’s 167 times larger than the wine market.
Yet collectibles historically lived up to their reputation as a store of value in inflationary times, according to the report. Real annual returns were positive during inflationary episodes, with art at 7%, wine at 5% and stamps at 9%.
“Moreover, we notice a possible distinction between art and stamps on the one hand, where performance markedly improves in inflationary periods relative to normal times, and wine, which experiences lower but more consistent returns between normal and inflationary times,” the research paper said.
The bottom line
When investing, you should understand that past performance does not guarantee future returns. When looking for smart ways of investing for inflation, an informed investor should interpret historical data with a pinch of salt, taking into account that the world is in a constant state of flux.
Oil stocks, for example, may behave differently as the world moves towards cleaner energy and electric vehicles amid mounting climate change concerns. A surge in oil prices may not have the same inflationary impact in the future.
Investors should always do their homework and analyse all factors in play. Economies remodel, their nature shifts between agriculture, manufacturing and services, sectors transform and consumer patterns change, which means the impact of inflation may vary. An investor should be alert to the wider context.
Some stocks will suffer during an inflationary shock as they cannot pass the increased producer costs onto consumers without losing revenue, which depresses their profit margins. Stocks with lower pricing power are especially vulnerable to inflationary pressure.
Historically, the stock market tends to react negatively to an unexpected inflation spike as increased price growth means a reduction in the value of money, which curtails a company’s ability to plan, grow and engage in longer-term contracts.
Some stocks, such as energy or commodity-linked stocks, tend to go up during an inflationary spike as rising commodity prices is often a cause of inflation. Other stocks tend to react to an inflationary shock negatively, depending on their ability to pass higher prices to consumers.