It’s often said that investors should avoid the stock market when the economy is locked into a rising inflationary cycle. As most of us will notice when going down to the supermarket for our weekly shop, we’ve been locked into a rising inflationary cycle for over a year now.
It’s perceived wisdom that investing in a period of inflation isn’t a good idea. Inflation hurts stocks overall as consumer spending falls. Growth-orientated stocks are generally shunned by investors, as the way to cap inflation is to slow down the economy. However, value stocks might do comparitively better, as they have the opportunity to catch up with their peers.
Stocks tend to be more volatile during periods of inflation. This means that the price of stocks can fluctuate more wildly, which can increase the risk of losing money. As input costs rise for companies, they themselves need to raise their prices to offset their own costs and expenses.
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This in turn can impact their bottom line, as consumers choose not to buy goods and services as they have other pressures on their household budgets. This impacts their share price. The main (and really only) tool that Central Banks have to combat inflation is raising interest rates. This makes borrowing more expensive, meaning companies must reallocate capital to repay their existing debt and find accessing new capital for investment and working capital more difficult and expensive.
For growing companies working through an inflationary cycle of raising interest rates it can take several quarters for the company to be able to pass on rising input costs to consumers. Although there is a benefit to inflation on the employment market, as more people come back into the workforce, for companies, rising inflation leads to the requirement to pay staff more to retain and attract employees, which again hits a company’s profit margins.
For investors, this can be confusing. Inflation appears to impact the economy and stock prices, but not at the same rate. Because there is no one good answer, individual investors must sift through the confusion to make wise decisions on how to invest in periods of inflation. Some types of stocks tend to perform better during periods of high inflation. Even analysts are confused at the effects of inflation on the stock market, but research has shown, in developed economies almost all stock markets suffered their worst real returns when inflation is high.
However, some stocks do well, so it comes down to a case of stock picking – selecting companies that aren’t correlated to the general economy and are doing something innovative despite the phase of the economy, or looking at sectors that continue to grow regardless of the state of the economy. Sectors including energy and healthcare.
Quality and valuation
As with all investments, the need to focus on company quality, growth and growth potential, valuation upside and potential capital returns. In an inflationary cycle a focus on company quality and company valuation is the key to navigating stock market volatility. The importance of a good history of dividends is also important in the current environment.
Prior to the period we are currently in, the world experienced two years of unprecedented interruption brought on by Coronavirus. Governments, especially in the developed world, responded with an exceptional period of monetary and fiscal stimulus and sectors of the economy – most notably healthcare and biotech – received vast sums of money to come up treatments and vaccinations to deal with the pandemic. Since then, things have changed. The war in Ukraine, the removal of stimulus, in the UK, a disastrous mini-budget from history’s shortest-serving Prime Minister, have all tipped the scale in the other direction. All this has contributed to the inflation we are seeing at the moment.
Some companies can absorb higher inputs and pass them onto customers much more easily – companies such as energy companies, utilities, to an extent food retailers. But other companies such as software companies and data companies are also quite robust in terms of passing-on costs as they have the advantages of offering essential or unique products and services.
Others such as consumer staples have an upper limit to what they can practically charge customers, and they have to absorb more of the costs themselves as by contrast the product or services they offer aren’t unique or have high barriers to entry. People-focussed business, such as consultancies or consumer-facing business such as fast-food retailers are also disproportionately affected by wage inflation.
The importance of continuing investing through inflation is to maintain your portfolio’s value and to keep your nest egg growing. Investing now is also an opportunity to diversify. Buying stocks that produce products or services that people ‘need’ as opposed to ‘want’ is the most simple inflation hedge. Also buying big and global is a good call, as multinationals have much deeper pockets than startups to see themselves through grim times, but don’t let inflation push your hand. Regardless of what is going on outside your window, all economic cycles come to an end and your long-term goals are what your portfolio should continue to reflect.