As the market spectre of rising inflation has come back to the fore, we look at what it is and which sectors can offer investors a shelter from it. The inflationary concerns rearing up at the moment are on a global level and fuelled by several catalysts including, a hangover from the lack of economic activity during the pandemic, China’s current lockdowns and impact on supply chains, and the conflict in the Ukraine.
If rapid inflation does set in, some product and service sectors can pass inflation on to their customers a bit easier than others in the form of a price increase. A lot of utilities can do so, as their pricing agreements with regulators tie price increases to the inflation rate. Vice stocks also offer inflationary covers largely due to the fact their consumers will continue to consume regardless of prices. This includes tobacco, gambling and alcohol stocks. Tobacco and alcohol companies have a lot of pricing power because consumers crave their products.
Luxury brands also offer a form of defence against inflation as the purchasing power of the luxury brand consumer doesn’t usually get dented quite as much as the spending power of the average man on the street. Whilst they can offer a hedge against inflation, they also have large exposure to China and the Asian markets and so with a lot of Covid, supply chain and growth concerns in China they may not be quite as defensive as they had been in the past.
Commodity stocks can also offer a shelter as the price of the underlying commodities tend to increase; this is even more prominent in the recent markets as talk of the beginning of a commodities super cycle is being bandied around (but that’s more of a topic for another article).
The final sector that can offer a shelter is defence stocks, whilst not the top of everyone’s list the contracts they win are with government bodies so avoid the knock on from consumer’s drop in buying power. The defence sector has also been under pressure for years especially in the UK as the government spending on defence has been weak for years, of course in the current climate this is changing.
What is inflation and what does it mean?
Inflation is the decline of purchasing power of a defined currency over a set period. This can be reflected in the increase of an average price of a basket of selected goods and services in an economy over a defined period. The rise in the general level of prices, often expressed as a percentage, means that a unit of currency effectively buys less than it did previously.
The basket (more commonly known as price indexes) generally includes the following mix:- commodities like metal and fuel, food grains, utilities, and services like healthcare and entertainment. Inflation aims to measure the overall impact of price changes for a diversified set of products and services and allows for a single value representation of the increase in the price level of goods and services in an economy over a period of time.
Types of Price Indexes
The two key price indexes are The Consumer Price Index and the Wholesale price index:-
The Consumer Price Index
The CPI is a measure that examines the weighted average of prices of a basket of goods and services which are of primary consumer needs. They include transportation, food, and medical care. CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them based on their relative weight in the whole basket. The prices in consideration are the retail prices of each item, as available for purchase by the individual citizens. Changes in the CPI are used to assess price changes associated with the cost of living, making it one of the most frequently used statistics for identifying periods of inflation or deflation.
The Wholesale Price Index
The WPI is another popular measure of inflation, which measures and tracks the changes in the price of goods in the stages before the retail level at the wholesale level. While WPI items vary from one country to another, they mostly include items at the producer or wholesale level. For example, it includes cotton prices for raw cotton, cotton yarn, cotton gray goods, and cotton clothing. Although many countries and organizations use WPI, many other countries use a similar variant called the producer price index (PPI).
Impact on Cash and Bonds
Whichever way you look at it, inflation is not good for cash. Money kept under the mattress will find its value eroded as prices rise and with it near impossible to find a savings account offering an inflation beating (or even equalling) interest rate, money held in a bank account could and probably will suffer. Inflation is not really that positive for bonds either. If prices rise at a rate greater than the interest you earn on a bond, you’ll find the value of your fixed income fall in real terms. Consider a five-year bond paying 2% nominal interest. If inflation rises to 2.5% for those five years, your bond won’t be able to keep up.
Causes of Inflation
An increase in the supply of money is one of the key root causes of inflation, though this can play out through different mechanisms in the underlying economy. Money supply can be increased by the monetary authorities either by printing and giving away more money to the individuals, by legally devaluing (reducing the value of) the legal tender currency, more (most commonly) by loaning new money into existence as reserve account credits through the banking system by purchasing government bonds from banks on the secondary market (quantitative easing). In all instances of money supply increase, the money loses its purchasing power. The mechanisms of how this drives inflation can be classified into three types: Demand-Pull inflation, Cost-Push inflation, and Built-In inflation.
Types of inflation
Demand-Pull Effect
Demand-pull inflation occurs when an increase in the supply of money and credit stimulates overall demand for goods and services in an economy to increase more rapidly than the economy’s production capacity. This increases demand and leads to price rises. With more money available to individuals, positive consumer sentiment leads to higher spending, and this increased demand pulls prices higher. It creates a demand-supply gap with higher demand and less flexible supply, which results in higher prices.
Cost-Push Effect
Cost-push inflation is a result of the increase in prices working through the production process inputs. When additions to the supply of money and credit are channelled into commodity or other asset markets and especially when this is accompanied by a negative economic shock to the supply of key commodity, costs for all kinds of intermediate goods rise. These developments lead to higher costs for the finished product or service and work their way into rising consumer prices. For instance, when an expansion of the money supply creates a speculative boom in oil prices the cost of energy of all sorts of uses can rise and contribute to rising consumer prices, which is reflected in various measures of inflation.
Built-In Inflation
Built-in inflation is related to adaptive expectations, the idea that people expect current inflation rates to continue in the future. As the price of goods and services rises, workers and others come to expect that they will continue to rise in the future at a similar rate and demand more costs/wages to maintain their standard of living. Their increased wages result in higher costs of goods and services, and this wage-price spiral continues as one factor induces the other and vice-versa.
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