Inflation is defined as the increase in the prices of goods and services in the economy. There are two widely used measures of inflation—the consumer price index (CPI) and the personal consumption expenditure price index (PCE). The CPI measures the out-of-pocket expenditures of urban households, whereas the PCE index measures goods and services consumed not only by all households but also by nonprofit institutions serving households. Given that PCE measures inflation more broadly, the Federal Reserve prefers PCE.
Inflation is a function of supply and demand and it can be either demand-pull or cost-push. The demand-pull inflation is a result of easy monetary or fiscal policy such as reduction in interest rates, stimulus checks and tax cuts. The cost-push inflation is a result of the increase in the cost of services and raw material costs that usually stems from supply disruptions.
In my opinion, the inflation that we are witnessing right now is both demand-pull and cost-push. The federal reserve has the mandate to control inflation, but interestingly, the Fed can only control the demand side of the inflation and not the supply side. If the Fed keeps extending the tighter monetary policies to control inflation, it might lead to reduced demand and, without reducing the supply side inflation, in turn, could lead to a recession—which is a likely scenario in the current economic environment.
How Inflation Impacts Equities Markets
Inflation impacts equity markets mainly in three ways:
Valuation: With higher interest rates, the future cash flows of companies have a lower present value and hence a company is worth less than before.
• Cost: The increase in the cost of goods and services reduces the profitability of companies.
• Foreign income: If a company has operations outside of the U.S., then a stronger dollar also reduces the revenue generated in foreign currencies.
The only silver lining in rising inflation is that it does not impact all of the sectors in the equities market equally and investors can overweight and underweight certain sectors to protect their portfolio. However, before I mention sectors that might outperform, there is another important part of the economy to consider—the growth of the economy.
Rising inflation might impact stocks differently depending on whether growth is rising or falling. Here are the sectors and assets that one can overweight or underweight in the portfolio (i.e., increase or decrease capital investment in sectors or assets). I have used artificial neural network regression models to classify sectors and assets in different business cycles. The regression model tries to find assets that have positive returns in different regimes. The results are as follows:
Rising Growth And Rising Inflation
• Overweight: financials, materials, industrials, technology, energy, real estate, consumer discretionary, gold and commodities.
• Underweight: defensive sectors such as utilities and consumer staples, communication services and long-term bonds.
Rising Growth And Falling Inflation
• Overweight: technology, real estate, consumer discretionary and industrials.
• Underweight: energy, utilities and communication services.
Falling Growth And Rising Inflation
• Overweight: cash in U.S. dollar, healthcare, energy, utilities and consumer staples.
• Underweight: financials, real estate and materials.
Falling Growth And Falling Inflation
• Overweight: government bonds, utilities, consumer staples and communication services.
• Underweight: financials, technology, industrials and high yield credit.
Having an understanding of how inflation and growth impact different parts of a portfolio will help better inform your financial decisions.
Is Inflation Here To Stay?
In my opinion, unless we find a solution to already high oil and other commodity prices and supply chain issues, the prices could remain elevated. If prices don’t rise further, then inflation may come down. That might help equities markets to go up, but your monthly bills might not come down.
Other Assets To Consider
When deciding on other assets, it is important to understand the economic drivers of asset classes. For example, stocks and bonds are considered to be negatively correlated and they have had a negative 30% correlation in the last 15 years according to our own models. However, when inflation increased in 2022, both the equities market and Treasury market were down, showing a positive correlation.
Therefore, it becomes really important to understand each asset class, each sector and their relative movements in different economic environments before making any investment decisions. Below are some of the asset classes you could consider during the current inflationary environment:
• Treasury Inflation-Protected Securities (TIP): TIPS are fixed income securities in which the principal amount is increased when inflation rises and decreased when inflation reduces, and accordingly investors receive the interest income. TIPS still have fixed income characteristics. Investors can take on pure inflation risk and benefit from rising inflation when TIPS are combined with other potential hedges.
• Commodity countries: Countries whose economy primarily relies on commodities export perform relatively better during inflationary times, such as Australia, New Zealand, Brazil and Canada. The important thing to note however for a U.S. dollar-based investor is to hedge for the currency exposure because if the USD would appreciate relative to foreign currencies, then that might erode the gains made in foreign stock markets.
• Equity market sectors: Based on the inflation and growth cycles, investors can choose sectors and assets mentioned above.
• Commodities: Commodities usually perform well during inflationary periods. It is important to diversify the portfolio and gain exposure to multiple commodities because individual commodities might have a sudden negative impact due to supply and demand characteristics.
• Cash: Sometimes it is not a bad investment to be in cash and not invest anywhere. Higher inflation might lower the purchasing power of cash but still, it is better than losing capital by investing in financial markets. Equity might outperform cash in the long term, but during turbulent periods, one can choose not to invest anywhere.
• Liquid alternative strategies: These strategies provide different exposure than typical stocks and bonds. These kinds of strategies usually show low correlation with stocks or bond markets and could perform better than traditional strategies during market turbulence.