Higher inflation would prove to be bad news for longer-duration equities such as growth stocks and more favorable to inflation hedge equities such as real assets, energy, materials and real estate. Equities in general perform better in a moderate increasing-inflation backdrop versus bonds. But what kinds of companies should you be investing in?
Who are the winners and losers from inflation?
The losers from inflation include retirees on largely fixed nominal incomes, bond holders (whose financial income is largely fixed) and those whose compensation is relatively fixed in nominal terms. Also among the losers are employees who do not see wage increases to match inflation. Lenders definitely suffer under inflation. So, unless you’re getting a 5.4% raise to measure up to that 5.4% inflation curve, you’re losing money.
There are a few winners when it comes to inflation. Examples include governments with high debt levels and borrowers on fixed repayment plans. Think of someone with a 30-year fixed rate mortgage with a set payment each month.
This is especially true if inflation is higher than expected. For example in the 1960s, markets expected low inflation so the government were able to sell government bonds at low rates of interest rates. However, in the 1970s, inflation was higher than expected – and higher than the bond yield on a government bond. Therefore owners of the bonds saw a fall in the real value of their bond, whilst the government saw a fall in the real value of its debt.
High rates of inflation can make it easier to pay back outstanding debt. Business that had borrowed large sums found that their debts had effectively disappeared due to inflation reducing the real value of debt. They also will be able to increase prices to consumers and use the extra revenue to pay outstanding debts. These businesses could buy up over firms who had gone out of business due to the costs of inflation.
Also winning, to an extent, are “debtors, investors in stocks, real estate, and physical assets such as gold and collectibles benefit from increasing inflation.
What is good investment during inflation?
In general, inflation is usually negative for stocks. Between 1973 and 1981, inflation rose by more than 9% a year. During the same period, stocks shed about 4% annually. But don’t panic! Either way, history shows that stocks beat inflation over the long term.
The average annual return on stocks was around 11% between 1900 and 2017, according to calculations by Steve Hanke, a professor of applied economics at Johns Hopkins University in Baltimore. After subtracting the cost of inflation, that average annual return remains a handsome 8%.
The best areas to invest in during periods of inflation include technology and consumer goods. Precious metals such as gold and silver have traditionally been viewed as good hedges against inflation. Gold cannot be subject to the same inflationary pressures as paper money as it cannot be printed. Land and property, like commodities, tend to rise in value during periods of inflation.
The best businesses during inflation are the businesses that you buy once and then you don’t have to keep making capital investments subsequently. Businesses like utilities and railroads as not good investments during inflation.
How does inflation affect the stock market?
Not all companies are affected in the same way; those with pricing power and less reliance on commodities will fare better than their less fortunate counterparts.
Higher inflation is usually looked on as a negative for stocks because it increases borrowing costs, increases input costs (materials, labor), and reduces standards of living. But probably most importantly in this market, it reduces expectations of earnings growth, putting downward pressure on stock prices.
In high-inflation environments, most companies are required to overstate their earnings. A 1981 study, for example, found that after adjusting for these factors, the earnings of 111 companies were 53% lower than the figures the companies reported. So, the uptick in inflation makes it harder to determine the true value of individual companies.
Is inflation bad for stocks?
Small cap stocks — particularly growth stocks— usually suffer because they are more sensitive to higher interest rates. High dividend stocks, like utilities and REITs, usually suffer as well because investors have higher yielding government bonds as a less risky alternative, and because dividends often do not keep up with inflation levels. Investors should focus on companies that can pass their rising product costs to customers, such as those in the consumer staples sector.
Companies that tend to withstand an inflationary environment must have two characteristics: (1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) an ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital.
Why is inflation good for value stocks?
There is correlation between value stocks and performing well during inflation because their value is less affected by rising interest rates. That’s because these companies are often in industries, such as the financial and consumer staples sectors, that get hit less hard by inflation. These industries have more pricing power and are able to increase their prices with inflation better than other industries. They are also usually already well established, and so you don’t have to worry as much about their expected growth waning in value. This is in contrast to growth stocks, which are often negatively affected by inflation because their value is expected to appreciate in the future. And as inflation increases, those future cash flows are worth less..
If you were to spend $100 buying into a value business on a price/earnings (P/E) ratio of 5x, say, that multiple suggests your shares should make $20 a year in profits, and so you will ‘get’ your money back after five years. In contrast, a growth business is likely to have a high P/E ratio, which means low profits today, but growth investors pay up in the hope of making their money in, say, years 16 to 20 rather than the first five.
While value stocks offer risks of their own, they tend to be firmly established companies, so investors do not need to worry about expected growth values impacting their investments.
How do you invest if you expect inflation?
In a high-inflation environment, it’s on the bond side where there’s a lot more trouble. If you’re living off coupon bond payments, for instance, you’re going to lose when there’s inflation. Bond investors can hedge against inflation by favoring shorter-term bonds and inflation-indexed bonds.
You might not think of a house as a good way to hedge against inflation, but if you use a mortgage to buy your house, it can be an excellent way to do so. With a long-term mortgage – at close to historically low rates – you’ll lock in cheap funding for up to three decades. And, of course, by owning a home you’ll have the potential for its value to increase over time. If more money is flooding the market, you can get price appreciation, too.
Investors often view gold as a store of value during tough economic times, and it has succeeded in this purpose over long periods. One good option for investing in gold is to buy it through an ETF, so you won’t have to actually own and protect the gold yourself. Plus, you have several options with ETFs, allowing you to own physical gold or the stocks of gold miners, which can offer higher upside if gold prices soar. However, it is worth bearing in mind, that in a period of inflation, buying gold is not guaranteed to increase in real value. This is because the price of gold can also be subject to speculative pressures. For example, the price of gold spiked in 1980 and then fell afterwards.
Stocks are a good long-term vehicle for hedging against inflation, even if they may get hit by anxious investors in the short term as their worries rise. But not all stocks are equally good inflation hedges. You’ll want to look for companies that have pricing power, so that as their own costs rise, they can raise prices on their customers or even charge more for their goods. And as a company’s profits grow over time, its stock price should climb. While the stock market might get hit by worries of inflation, the best companies power through it with their better economics.
What stocks benefit from inflation?
Rising inflation is a big concern for investors right now, but it remains to be seen whether high levels of inflation will persist or end up being due to “transitory” factors. Stocks still tend to beat inflation even though their growth might be slowed. Investors, if they own individual stocks, could evaluate which of their holdings is most exposed to inflation and consider paring back that exposure or perhaps not adding to the position further.
Some stocks you maybe like during inflation:
Morgan Stanley (NYSE: MS)
Johnson & Johnson (NYSE: JNJ)
Amazon (NASDAQ: AMZN)
Microsoft (NASDAQ: MSFT)
Chevron (NYSE: CVX)
Devon Energy (NYSE: DVN)
Goldman Sachs (NYSE: GS)
Eli Lilly (NYSE: LLY)
Salesforce (NYSE: CRM)
Adobe (NASDAQ: ADBE)
Workday (NASDAQ: WDAY)
Best Buy (BBY)
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