Understanding Inflation

Individual product price changes are simple to track over time, but human requirements go beyond one or two items. Individuals need a large and diverse range of goods as well as a variety of services in order to live comfortably. Commodities such as food grains, metal, and fuel, utilities such as power and transportation, and services such as healthcare, entertainment, and labour are among them.

Inflation is a term used to describe the overall effect of price changes across a wide range of goods and services, and it provides for a single value representation of the rise in the price level of goods and services in an economy over time. Prices increase when a currency loses value, and it can purchase fewer products and services. This loss of buying power has an effect on the overall cost of living for the general population, resulting in a slowdown in economic growth. Economists agree that persistent inflation happens when a country’s money supply grows faster than its economic growth.

To counteract this, the relevant monetary authority in a nation, such as the central bank, takes the required steps to control the supply of money and credit in order to maintain inflation within acceptable bounds and the economy operating smoothly. Monetarism is a common hypothesis that explains the relationship between inflation and an economy’s money supply.

 

The financial press is full of the inflation debate and what that means for your investments.

  • Two questions are important: Is the inflation transitionary?
  • Are stocks a good inflation hedge?

Is the inflation transitionary?

What this means is the notion that the inflation we are experiencing now, will go away as it is a statistical oddity. As Inflation is compared year on year, we are now measuring prices to the middle of the COVID-19 crisis. The reasoning is as economic activity was low and prices were probably depressed, we see a higher inflation now. This is not true though: the COVID crisis was a supply crisis, not a demand crisis. Prices went up during COVID lockdowns. That aside, whether inflation is transitionary is determined whether the inflation is leaking into wages. If wages go up, they don’t go down afterwards, putting a permanent pressure on prices. We see evidence of this in the US (labour shortages, people being paid to do an interview), but I have seen not a lot of evidence in Australia for this, but my hunch is that we will see increased wages. It is important to note that even if price rise slows in the coming months, 12-month inflation rates will remain strong. Headline CPI has already risen enough in the first seven months of the year that even if monthly price rises were to fall to zero, annual headline inflation would still be 4.1 percent. Price reductions in the coming months (possible in some industries, but doubtful in others) would be required to reduce 12-month headline inflation anywhere near the 2-3 percent level. However, the claim that inflation is only temporary does not need a low 12-month inflation rate; it only requires inflation to return to the 2% range in the future.

We do not anticipate a normal rebound from the COVID-19 epidemic, which has created an unusual recession. While the most important policy objectives are to contain the virus, achieve full employment, and make the required investments for a more robust and inclusive recovery, economic uncertainties and dangers must be carefully monitored in the future. Inflation is one danger that the administration is keeping a careful eye on.

Are stocks a good inflation hedge?

Sometimes I hear people say: just buy stocks when there is inflation. Today I read an interesting article that looked at high inflationary environments and what was best to buy. Only Coal and Oil were consistent winners! Normal stocks have problems repricing their good in a high inflation environment. The only thing I would add is that we have never seen a high inflation environment while having a digital industry. We don’t know whether the digital industry is able to cope better with inflation than other consumer companies. It seems logical that Oil will follow past trends when inflation has been proven not to be transitionary.

Stocks are an excellent long-term inflation hedge, even though they may be hammered by nervous investors in the near term as their concerns grow. However, as I have said, not all equities are equally excellent inflation hedges. You’ll want to search for businesses with pricing power, which means they can increase prices on their consumers or even charge more for their products when their own expenses grow. When equities are split into growth and value categories, it becomes apparent that value stocks outperform growth stocks during times of high inflation, while growth stocks outperform value stocks during periods of low inflation. Commodity markets are one method for investors to anticipate projected inflation, but there is a propensity to believe that if commodity prices are increasing, stocks should increase as well since businesses “produce” commodities. High commodity prices, on the other hand, typically compress earnings, lowering stock returns. As a result, keeping an eye on the commodities market may help you predict future inflation rates.

In times of high inflation, value stocks perform better, whereas growth stocks perform better in periods of low inflation. When inflation rises, stock prices for income-oriented or high-dividend-paying companies tend to fall. Stocks seem to be more volatile in general during times of high inflation.

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