Why should stock investors worry about inflation?

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As the specter of rising inflation has returned to the forefront, we take a look at what it is and which sectors can offer investors shelter from it. The inflation concerns emerging at the moment are global and fueled by several catalysts, including the hangover from lack of economic activity during the pandemic, the current lockdowns in China and their impact on supply chains. supplies, and the conflict in Ukraine.

If rapid inflation sets in, some product and service sectors may pass inflation on to their customers a little more easily than others in the form of increased prices. Many utilities can do this because their pricing agreements with regulators tie price increases to the rate of inflation. Vice stocks also provide inflationary hedges largely due to the fact that their consumers will continue to consume regardless of prices. This includes tobacco, gambling and alcohol stocks. Tobacco and alcohol companies have great power over prices because consumers crave their products.

Luxury brands also offer a form of defense against inflation, as the buying power of the luxury brand consumer is usually not as shaken as the buying power of the average man on the street. While they may offer inflation hedging they also have a large exposure to China and Asian markets and so with a lot of Covid, supply chain and growth issues in China they may not be as defensive as they had been in the past.

Commodity stocks can also provide shelter as the price of the underlying commodity tends to rise; this is even more important in recent markets as we talk about the start of a commodity super cycle (but that’s more of a topic for another article).

The last sector that can offer shelter is defense stocks, even if the contracts they win are not high on the list with government agencies, so avoid the repercussions of declining consumer purchasing power. The defense sector has also been under pressure for years, particularly in the UK, as public spending on defense has been low for years, of course in the current climate this is changing.

What is inflation and what does it mean?

Inflation is the decline in the purchasing power of a defined currency over a given period. This can be reflected in the increase in an average price of a basket of selected goods and services in an economy over a defined period. The rise in the general price level, often expressed as a percentage, means that a currency unit is effectively buying less than before.

The basket (better known as price indices) usually includes the following combination: – commodities like metal and fuel, food grains, utilities and services like health care and entertainment . Inflation aims to measure the overall impact of price changes for a diversified set of products and services and allows a single value representation of the increase in the price level of goods and services in an economy over a period of weather.

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Types of price indices

The two main price indices are the consumer price index and the wholesale price index:-

consumer price index

The CPI is a measure that examines the weighted average of the prices of a basket of goods and services that correspond to the primary needs of consumers. They include transport, food and medical care. The CPI is calculated by taking the 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 taken into consideration are the retail prices of each article, such as they are available for the purchase by the private individuals. Changes in the CPI are used to gauge price changes associated with the cost of living, making it one of the most frequently used statistics to identify periods of inflation or deflation.

The wholesale price index

The WPI is another popular measure of inflation, which measures and tracks changes in the price of goods in the stages preceding the retail level to the wholesale level. Although WPI items vary from country to country, they primarily include items at the producer or wholesaler level. For example, it includes cotton prices for raw cotton, cotton yarn, cotton gray goods, and cotton garments. Although many countries and organizations use the 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 money. Money kept under the mattress will see its value erode as prices rise and with it nearly impossible to find a savings account offering an interest rate beating (or even matching) inflation, money held in a bank account could and probably will suffer. Inflation is not really positive for bonds either. If prices rise at a rate greater than the interest you earn on a bond, you will find that the value of your fixed income falls in real terms. Consider a five-year bond paying a nominal interest of 2%. If inflation rises to 2.5% during those five years, your bond won’t be able to keep up.

Causes of Inflation

An increase in the money supply is one of the major root causes of inflation, although it can manifest through different mechanisms in the underlying economy. The money supply can be increased by monetary authorities either by printing and giving more money to individuals, by legally devaluing (reducing the value of) legal tender money, more (most often) by lending new money as reserve account credits through the banking system by buying government bonds from banks in the secondary market (quantitative easing). In all cases of increase in the money supply, the currency loses its purchasing power. The mechanisms of how this drives inflation can be categorized into three types: demand inflation, cost inflation, and embedded inflation.

Types of inflation

Demand pull effect

Demand-pull inflation occurs when an increase in the supply of money and credit stimulates the aggregate demand for goods and services in an economy to rise faster than the economy’s productive capacity. . This increases demand and leads to price increases. With more cash available to individuals, positive consumer sentiment drives increased spending, and this increased demand drives prices higher. This creates a gap between supply and demand with higher demand and less flexible supply resulting in higher prices.

Cost push effect

Cost inflation is the result of raising prices through inputs to the production process. When additions to the supply of money and credit are channeled into commodity markets or other assets and especially when this is accompanied by a negative economic shock to the supply of key commodities, the costs of all kinds of intermediate goods are increasing. These developments lead to higher costs for the finished product or service and are reflected in higher consumer prices. For example, when an expansion in the money supply creates a speculative boom in oil prices, the cost of energy for all kinds of uses can rise and contribute to higher consumer prices, which is reflected in various measures of inflation.

Built-in inflation

Embedded 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 increases, workers and others come to expect them to continue to increase in the future at a similar rate and demand more costs/wages to maintain their quality of life. The increase in their wages leads to an increase in the costs of goods and services, and this price-wage spiral continues when one factor induces the other and vice versa.

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