Whether inflation is real, transitory, or imaginary – in the end, it does not matter. The market prices in expectations of future movements. If the market thinks inflation is coming, assets & pricing will move accordingly. Perception is reality when it comes to the way prices move.
A walk back in time
Is there a link between inflation and share market returns? Unfortunately, there is no clear answer. Numerous studies have produced conflicting results, especially over different periods.
The studies that link inflation and share market returns tend to be pre-1980, while the studies that show that there is no link, tend to be post-1980.
In Australia, the Reserve Bank only started to target inflation in the early 1990s so finding a link can be even more difficult.
Source: Australian Bureau of Statistics, IRESS, Burman Invest. Inflation, XAO 1950-2019
Let us look at two periods: The years between 1973-1990, characterised by rising interest rates and high inflation & those years of 1991-2007, characterised by falling interest rates and lower inflation. While there have been low performing and high performing periods of the share market, it is difficult to attribute this to a single factor as there were many influences on the market. These include the abolishment of the gold standard, which led to a rise in money supply, central banks targeting inflation and also structural trends which have impacted returns.
Effects of inflation
Apart from prices generally rising, what are the impacts of a rise in inflation? An inflationary environment is usually one where interest rates are rising. It is also one where companies are raising prices.
A key issue for investors to consider is whether a company can pass on the rising costs, absorb some/all those costs, or can increase margins in the face of rising costs. The last scenario is the most positive for investors.
Hedging against inflation
Real assets (property, infrastructure) and commodities are seen as assets that hold value in times of inflation. Real assets are usually tangible or something that you can touch. Hikes in the price of road tolls are linked to rises in inflation showing a positive relationship to inflation. As inflation rises, so do toll prices making toll roads an effective inflation hedge. Other infrastructure assets have a link to inflation through regulation or contracts. Commodities also tend to do well. Usually, if interest rates are rising, the economy is strong and hence commodities are usually in high demand. Commodities as hard assets are seen as an inflation hedge.
Interest rate sensitivity
For tech and growth stocks, expected rising interest rates have impacted negatively on valuations. This was especially apparent when bond yields were rising rapidly in February/March 2021.
Earnings driving the share price
Focus has turned to cyclical stocks which were seen as better value. Cyclical stocks are businesses that do well when the economy is doing well. This includes banks, miners, and industrial companies. Cyclical stocks are in an upgrade cycle with the most positive earnings revisions coming from banks, financial companies, and miners this year. In contrast, many of the Australian tech companies (NEA, APX, ALU) have been seeing negative earnings revisions.
Inflation eats away at savings. To counter rising costs, investors need to consider investments that will increase greater than inflation. Traditionally this has been hard/real assets and/or commodities. While a quick rise in inflation is expected to result in market volatility, strong companies which produce rising earnings should continue to perform in the long run.
At Burman, we look at investments through three lenses. We take into account the macro environment, examine the company fundamentals and finally incorporate technical analysis to help time entry and exit points.