Is inflation good or bad for stocks? July 30, 2021

This article is part of a 3-part series on inflation.

In this first part, we look at inflation, its causes and effects, its impact on stock markets and investment portfolios and inflation expectations over the short and long terms.

At a glance:

• Inflation is a general increase in the prices of goods and services. Types of inflation include demand-pull and supply-push inflation.
• Inflation brought about by economic expansion may not be a bad thing. The danger is runaway inflation, which over-heats economies and triggers recessions.
• Inflation typically hurts growth stocks more than value stocks, as the discount on their future cash flows is bigger.
• Current inflation is high due to supply-chain disruptions, pent-up demand during COVID-19 and the base effects of 2020’s economic downturn.
• Longer-term inflation is expected to normalise after the short-term inflationary pressure eases.

Headlines on inflation have been instilling fear in investors. But is inflation a good or bad thing?

There are four main causes of inflation. Some drive inflation for the correct reasons, such as economic growth. If inflation is kept in check, there should be no reason to fear it as it is usually an indicator of steady economic growth.

The current environment may reflect stronger-than expected inflation, which would be a tailwind for value stocks. But once inflation normalises over the longer term, growth stocks are expected to outperform again, thanks to structural shifts in the economy.

Investors may find out more on inflation in our past webinar on ‘Insulating Wealth Against Rising Inflation’ here.

Fig 1. Inflation eats away money¹

What is inflation?

Inflation is the rate of increase in the prices of goods and services. It can come about from:

• Demand-pull forces: This is known as demand-pull inflation. Strong consumer demand stems from a strong economy that has low unemployment and rising wages. This translates to higher consumer confidence and spending. With higher demand, prices rise.
• Supply-push forces: This is known as supply-push inflation. It occurs when a surge in production costs due to shortages of inputs such as raw materials or labour jacks up the prices of end-products.
• Expansionary fiscal policies: Direct cash transfers to or tax cuts for companies and consumers increase disposable income. With higher purchasing power, companies and consumers spend more, lifting demand.
• Expansionary monetary policies: Lower interest rates encourage borrowing by consumers for spending and companies for investments. This increases money supply, spending and demand in the economy.

Inflation that is brought about by an expanding economy is not necessarily negative for the economy. However, if sustained, inflation will erode the purchasing power of consumers, especially those whose investments are mainly in fixed-return instruments such as bonds. Bonds pay fixed coupon payments. Inflation could cause those investors to buy less than they once did as their investment returns do not change despite higher prices.

A simple example of inflation is a plate of chicken rice that used to cost less than S$3. Today, it can cost anywhere from S$3 to S$5, depending on where you eat your chicken rice.

Runaway inflation occurs when prices rise too fast. This eventually affects the ability of consumers to spend. The drop in demand forces businesses to cut costs and scale down. In rare cases, excessive inflation leads to hyperinflation, when prices spiral out of control. Hyperinflation often occurs in times of economic or political turmoil, when a country’s central bank feverishly prints money to pay for its spending, sending prices higher.

The best-known historical example of hyperinflation was Germany during World War 1. German hyperinflation, at its height, was more than 30,000% a month. The most recent example of hyperinflation is Venezuela in 2018, when prices in the country catapulted 65,000%!

Fig 2. Self-fulfilling prophecy of inflation expectations

You may not be fully aware of this, but inflation expectations heavily influence actual inflation. Expectations can be self-fulfilling. If an economy is expecting inflation to be X%, businesses would want to increase their selling prices by at least X% to maintain the same level of profitability. An increase in inflation or inflation expectations is also usually accompanied by an increase in interest rates. This is because when prices rise, the Federal Reserve in the US would want to raise interest rates in an attempt to maintain price stability. Rates are raised when inflation surges and lowered when inflation drops.

Growth vs. value: Why inflation is good for value stocks

How does inflation affect your portfolio?

As we’ve already pointed out, inflation affects the returns of investors of fixed income. But inflation also affects stocks, more so growth stocks than value stocks.
During inflation, growth stocks tend to perform worse than their value counterparts. This is because growth stocks derive most of their value from their future earnings, which are discounted in a rising-interest-rate environment. Value stocks derive most of their value from their current earnings, with limited discounting of their future earnings.

Furthermore, growth companies are known to take on more debt than value companies to support their rapid expansion. Their higher debt translates to higher interest payable when interest rates rise. This decreases their profitability.

Put together, the higher discounts of future cash flows and higher interest payable affect the value of growth stocks more than value stocks. Thus, in an environment of inflation, a portfolio with more allocation to growth stocks may underperform the one with more allocation to value stocks.

A caveat, though. Value stocks usually pay dividends. The real return of their dividends can be equally eroded by inflation over the longer term.

Inflation in the short term

Fed officials describe the current bout of inflation as transitory, meaning it should go away. They are expecting several months of elevated price increases because of pent-up demand, supply-chain lags and last year’s weak prices when the global economy was largely shut down.

Supply-chain disruptions around the world have two major effects. They lead to limited supply of key components for producing goods. This means producers have to pay a higher price to secure their raw materials. This, in turn, limits the amount of finished goods, which causes demand to outstrip supply.

Both will push up prices. The most obvious example is the current global shortage of semiconductors, which are used to produce anything from cars to handphones.

During COVID-19, many governments also made direct transfers of cash to their citizens to tide them over the crisis. The combination of income support and decreased spending elevated savings rates in the US to 28% in March 2021, much higher than the average pre-crisis saving rate of 7.5%².

Now that uncertainties from the pandemic are dissipating with vaccinations, consumers are likely to be more confident about spending their disposable income. Pent-up demand following subdued spending during lockdowns has created demand backlogs, especially for discretionary goods and services. This is evident in the current upsurge in air travel in the US, where volume at airport checkpoints is six times higher than a year ago³.

Due to low inflation last year, current YoY inflation numbers are also inflated. Had there been no pandemic, headline inflation this year would have been roughly 2.9%, rather than the reported 4.2%, which is spooking investors⁴.

Add these factors together and inflation is most likely here to stay in the near term.

Inflation in the long term

Longer term, inflation could normalise once the various influences fade.

One example is the recent jump in wages in the US economy. June’s wage hikes in the US were caused by a shortage of labour supply, despite a high unemployment rate of 5.8% or 9.3mn unemployed compared to a pre-pandemic low of 3.5% when 5.7mn were unemployed⁵. The wage inflation may be attributed to fiscal support from the government, which might have acted as a disincentive for people to look for jobs when they can live off benefits. When fiscal support ends sometime in early September, wages are likely to return to normal⁶. Consumer spending may then drop and wage inflation settle down once people start to look for jobs.

The view that inflation will be transitory can be further supported by our simple observation that not all pent-up demand will translate into actual spending. Think of this: a person who used to travel four times a year before the pandemic may not necessarily want to cram in four trips this year, or even next. In his testimony before the US House financial services committee, Fed Chairman Jerome Powell said he believed the current inflation is directly linked to the reopening of the economy. He expects inflation to settle down in the middle or latter part of 2022, when the economy normalises⁷.

Balancing inflation

Inflationary pressure in the short term has roiled markets. Should inflation stay consistently above estimates, the Fed will be forced to act sooner than later to stabilise prices. This may trigger further corrections in the market.

On the other hand, if inflation is controlled, it can serve to support sustainable economic growth. This is good news for markets. The Fed can be trusted to deploy its arsenal of policy tools to keep inflation within its comfort zone over the longer term. As such, investors should pay close attention to Fed decisions on interest rates for the direction of market movements.

Enjoy what you read? Stay tuned for the next articles in the series!

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