Inflation: How Does it Affect Investment Stocks?

The late 1970s. An era defined by bell-bottoms, some big characters, dubious fashion, disco, and high inflation. We cannot accept high rates of inflation as a permanent fact of American life. Flares may now be a relic of the 20th century, but some economists fear a return to high inflation, the likes of which have not been seen Inflation is on the rise. Inflation. Inflation is a real concern. And since the start of 2021, it has been rising steadily across the world. Inflation could be a lot less temporary than some of the central banks seem to think it is. We're experiencing a number of novel developments that we have rarely observed in the past. The cause? Now to growing concerns about the deadly coronavirus. The pandemic has created a set of highly unusual economic conditions. High inflation is detrimental to a healthy economy. If it lasts longer, it will affect the stock market, it will affect consumers, it will affect the economy a lot. Stop it, will you? If inflation continues to rise, what effect will it have on the stock market and your wealth? When COVID-19 sparked a global lockdown, markets plummeted. You must stay at home. You must stay at home and limit contact. Do not travel abroad. You could describe it as panic, with investors dumping all sorts of risk assets, including stocks. Goodness, look at those numbers there. An economic shock of unknowable scale is upon us. Fears of COVID-19 gripped the nation. We were seeing fairly vicious falls almost every day. The pandemic disrupted global supply chains. Production lines came to a standstill. Shipping stalled and air freight were grounded. I think plenty of people thought that this could well be the start of a bear market. But within five weeks, something extraordinary happened. The S&P 500, which tracks the 500 largest companies in America, had plummeted in March 2020. But it soon rallied and its value doubled over the next 18 months. It felt like it almost shrugged off the effects of the coronavirus or factored it in very quickly and it was back to business as usual. Lockdowns meant that people were spending less than before the pandemic. At the same time, governments were taking unprecedented steps to recharge their economies. The single biggest economic relief package. One of the largest emergency aid packages. Chancellor Angela Merkel has agreed a bumper stimulus package. For the first time in our history, the government is going to help to pay people's wages. In the US alone, the government has allocated more than $4 trillion on stimulus funding. Congress adopted an approach that was aimed at supporting incomes of US families across the US. And the idea was that in the presence of massive job losses, the key intent was to support income. All of this fiscal stimulus really supercharged consumer spending. We saw central banks lower interest rates because the cost of borrowing is low. And QE, quantitative easing, effectively pumping money into the economy, a lot of which finds its way into markets to try and prop up and avoid any sort of massive crash. John Q has a private little nest egg. His practical nature tells him it ought to do more than collect moths. In a world of low interest rates, consumers look elsewhere for better returns on their investments. What are you going to do with your cash? You don't want to leave it in the bank if you sold off in the worry of a bear market. You're getting not very much return leaving it in a savings account. So it's going to find its way into the stock market. But the pandemic limited the supply of goods. And since economies have reopened, supply has been playing catch up with that newfound surge in demand. That has led to a rapid increase in inflation. We saw the categories like motor vehicles, like cars, see a rapid acceleration in prices and in inflation. It means your dollar or pound or yen won't buy as much tomorrow as it did today. These lines chart the price of the two most popular oil stocks, West Texas Intermediate and Brent Crude. After falling to historic lows in April 2020, the prices of both types of oil have recovered sharply. We have not seen supply of oil come back to its pre-COVID level. We've seen restraint on the front of OPEC and we've seen restraint on the US front in terms of oil production. Crude oil prices and natural gas prices have really surged. The heads of a number of central banks have used cautious language this year, saying that inflation is a transient thing or that you think it's going to be temporary. They're right to calm fears. Psychology plays a role in all of this, too. I don't know why I'm telling you this. I'm a dentist. You're the psychoanalyst. If consumers fear long term, higher rates of inflation, it can quickly become a self-fulfilling prophecy. Was that fair, doctor? Tell me honestly what you think. As they quickly spend In that environment, we are in what is called a price spiral and essentially this risks having runaway inflation. We're not in that inflationary psychology right now. Traditionally, central banks have controlled inflation by raising interest rates, which makes borrowing more expensive. Their real fear is hyperinflation, examples of which are strewn through history. In these cases, currencies became worthless. No one is suggesting that any major economies are heading for hyperinflation, but any period of higher inflation does have a knock-on effect on the stock market. Historically, inflation can spell bad news for companies' stocks. Take a look at the Dow Jones Index. It measures 30 of the best performing companies in the US. The red line charts its performance over the last 14 years. Between 2007 and 2011, when the US rate of inflation, that's the blue line, moved above 3%, the index reacted negatively. First in 2008, when inflation spiked during the subprime mortgage crisis, the Dow lost almost half its value. And again in 2011, when an inflation increase was soon followed by a weaker index value. When it comes to periods of higher inflation, markets and investing can get a lot trickier. Some stocks traditionally outperform in times of higher inflation. Duke University in North Carolina recently published a paper looking at historical returns over the past 95 years of different US equity sectors when inflation moved above 5%. Researchers focused on eight sustained periods of inflation from 1926 to 2020. When normal demand and supply patterns were jolted by global conflict, We are determined to preserve our freedom no matter what the cost. oil embargoes, Oil reserves are running out. revolution and economic booms. The legislative process to put America back on the road to economic health is now fully underway. Of course, historical trends are never a guarantee of future performance, but the researchers found that across all sectors, energy stocks deliver the best positive annual returns. Companies that produce gas, that produce oil, that produce renewable energy, they will all be thriving during inflationary times, but it is because inflation is caused by increase in energy prices. Soft commodities, such as corn, wheat, fruit or livestock have also historically held or increased their stock prices. And this is holding true today. Since January 2021, the three best performing soft commodities have soared in price. The researchers at Duke University found that commodities offered on average a 14% return on investments during periods of high inflation. Historically, the fate of bank stocks during periods of high inflation has been hard to gauge. How much are you going to start off with? Five shillings, good. When inflation hits, there is an expectation of an interest rate hike from central banks. So in theory, banks should benefit from that because an interest rate hike makes it more profitable for banks to lend money. Well, I think we can make it this long. Well, the bank needs security. No, I don't think so. Inflationary pressure, however, can also signal that an economy is in difficulty, ideal conditions for debt defaults to arise. This seems OK. Banks are very, very embedded in that economic cycle dynamics. So they actually might get hit by the sort of recession that may follow an inflation spike. Then there are the less flashy, age-old stocks, which typically offer steady but not spectacular growth rates. These are known as value stocks. As investors become a bit more concerned about the economy and the effect that higher inflation could have on it, they could turn away from perhaps some of the more aggressive go-getter tech-type stocks, for example, and look to a more traditional blue-chip dividend yield, slightly safer play. We took a look at the top three growth stocks and the top three value stocks based on index weight according to the S&P Growth and Value Index. We studied the relationship when the rate of inflation moved above 2%. The price of these growth stocks tends to decrease more quickly than the price of the value stocks as the rate of inflation increases. Technology stocks could suffer if we had higher inflation, some of them anyway. Clearly, some of the big names, if we take the likes of Facebook, Amazon, Netflix, Google, they weren't around in the 1970s when we had runaway inflation. So it's difficult to know how they will be impacted. Instead of focusing on potential growth in times of inflation, investors tend to look at how much leverage or debt a specific company or stock has taken on. Value stocks are typically better placed in this respect. It's unlikely that rich economies are headed back to the kind of double-digit inflation last seen in the late 70s. I want to have a frank talk with you tonight We are going to see some cooling of inflation, but inflation is likely to remain persistently higher than it was in the decade before the COVID crisis. If we do see interest rates gradually get ratcheted up, that could be perhaps something of a bigger shock than stock markets were expecting and could be a reason for people to perhaps head for the exits gradually on stock markets. A more likely scenario is a period of what's known as stagflation, where inflation rises at the same time as the economy slows. Either way, there will be opportunities for traders and investors to capitalise on the changing economic climate. I'm David Jones, Chief Market Strategist at Capital.com. We've written a piece on how commodities, value and growth stocks perform during periods of higher inflation. It's available on our platform. Click on the link. And don't forget to hit the subscribe button to stay alerted to new films on topics like this in the future.