For several months now, media outlets have been bashing their heads with the same redundant headlines about “inflation”. Articles are being written every week warning investors, and the stock market sometimes plunges on the news of unexpected inflation. At first, inflation was conveniently tagged as “transitory”, but three weeks ago, the chairman of the U.S. federal reserve, Jerome Powell,stopped qualifying it as such. This pile of information and news might leave a lot of us confused, this is why we will try to explain and answer some questions you might ask yourselves. How is inflation going to impact my portfolio? What about short-term news? Should I care about a possible interest rate increase? Many of you might already know a lot about the impact of inflation and interest rate on the economy or the financial markets, but this article may still expand some of your knowledge on the issue.
First, we will try to explain what and how inflation works. It is a subtle subject that has been teasing economists for centuries, so we will not get into too much details. Several economic theories try to explain the cause of inflation, the Quantity Theory of Money being the most accepted one. According to its principles, the general price level of goods and services is proportional to the money supply in an economy, and an increase in the money supply results in an increase of price levels, or an increased supply of goods and services, or both.
This is very theoretical, but applied to 2020/2021, it would explain how the bond-purchase programmes of the Fed and the ECB led to increased prices. As a reminder, the Federal Reserve of the United States and the European Central Bank have both been injecting extra large amounts of money since the start of the pandemic in order to support financial markets and avoid a recession. However, it has been proven that an increase in the supply of money alone is not enough to cause inflation.
Moreover, through 2021, the world suffered from several supply-chain issues, these caused shortages for many raw materials, the scarcity then made prices go upwards. Then, some countries also suffer from labor shortages, causing an increase in wages, the augmentation of supply and wage prices also cause inflation as companies have to increase their price to stay profitable. The high demand from consumers for products since the end of lockdowns generates even more pressure on the supply and inventories, also inducing inflation.
Now that we have finished the quite arduous task of understanding inflation, let’s dive into its actual effects on your portfolio.
Most of the time inflation does not have a negative impact on the stock market, a small inflation rate such as 2% is seen as healthy for the economy. It encourages people to spend their money and/or invest, stimulating growth, hence companies do well. However, if the inflation rate suddenly increases or decreases when economic agents were not expecting it, it might lead to abrupt negative reactions. Indeed, unexpected inflation invalidates or reduces the validity of information on market prices for investors that need to react quickly to adjust their models and investments to keep the same real rate of return. Moreover, as inflation grows, investors try to anticipate a higher interest rate.
Then, it is interesting to look at other asset classes, for example commodities. Inflation is computed using a weighted index of prices of different goods and services - some of them raw materials. Hence, in times of inflation, commodities tend to do very well.
So the question is, what or who should we invest in in times of inflation? Well, different stocks react differently to inflation. Growth stocks for example, tend to underperform in times of inflation, indeed, these companies have high expected future earnings and when inflation increases (Schroders, 2021), these earnings are discounted at a higher rate and hence are worth less. High-dividend stocks also suffer, as their dividends usually do not keep up with inflation levels. Value stocks however, tend to do better, their profits are less variable and closer to the present, hence inflation and higher discount rate hurt them less. Generally, companies that have a high pricing power also do well when inflation is high as they are not dependent on others to set their prices, thus they can transfer their additional costs directly to their customer. To find companies with a high pricing power, look for firms with stable margins.
When inflation grows, governments try to protect economic agents, to do so, they usually raise interest rates. This boost in interest rate also induces changes in the financial markets. Interest rate influences the price of borrowing, making debt more expensive for companies or individuals. We will now explain how this impacts the financial markets. As rates increase, government bonds, usually seen as the safest investment, also see their yield increase, making them more attractive for investors (for bonds, when yields increase, price decreases). In equity markets, profits should decrease as debt is more expensive for companies, reducing the estimated amount of future cash flows the companies receive, lowering the price of its stock. Moreover, the increase in the yield of risk-free assets can make the equity seen as too risky.
Finally, some industries still benefit from an increase in interest rates, it is the case for banks, brokerages or mortgages companies, indeed, as the cost of borrowing/lending increases, these firms can raise their price and increase margins.
To conclude, as central banks are changing their strategies towards inflation, investors should also shift their positions to maybe take advantage of these new opportunities. They should be less exposed to growth stock which might do worse than value stock, especially companies with a high pricing power. Concerning interest rates, companies in the financial sector could benefit from an increase, whereas companies relying a lot on debt will see a surge in their financing cost.
Schroders, 2021. Why does inflation tend to be good news for value investing?. [online] Why does inflation tend to be good news for value investing?. Available at: [Accessed 21 December 2021].