History offers no clear path for the future, including the course of the economy once central banks end their extraordinary monetary policies. Outcomes from a rise ininterest rates range from an Inflationary boom, Deflationary slump, or Stagflationary swamp; each has implications for the ways your portfolio is managed.
Investors can turn to history to understand the implications of each scenario and for guidance for the best-performing asset classin each case.
Meaning of Inflation in Economy and Definition of Inflation Rate
In simple terms, Inflation is the phenomenon that characterizes the rise of goods and services. High Inflation is characterized by rising prices and a decline in purchasing power. For instance, if Inflation Rate is at 10%, consumers would need to spend $110 to purchase goods that would have previously cost them $100.
Types of Inflation
Broadly speaking, there are two types of Inflation that impact prices. This includes:
A. Demand-Pull Inflation— Demand-Pull Inflation occurs when the demand for goods or services exceeds that of the supply that currently exists in the markets. When demand-driven Inflation occurs, too much money is chasing too few goods.
B. Cost-Push Inflation— Cost-Push inflation is signified as a result of rising input costs to deliver goods and services. There are three factors that can contribute to cost-based Inflation, including an Increase in Commodity Prices, a Rise in Wages, and an increase in corporate taxes.
While Inflation in the U.S. has historically been low (averaging 3.6% over the last 60 years), it has rapidly been on the rise recently. Over the last 18-months, the U.S. has experienced a combination of both demand-pull and cost-push inflation.
This includes Covid-related favorable monetary policies such as low-interest rates and fiscal stimulus, which has increased the broader money supply, combined with record levels of employment and supply chain shortages.
Investing During Inflation
In scenarios when Inflation is on the rise (such as the current landscape), companies tend to post higher revenues and profits. Despite this, higher input costs and margin pressures can lead to stocks underperforming.
High-growth and tech stocks have performed well during periods of high Inflation, but rising interest rates that are implemented to thwart Inflation can lead to under-performance over the short term.
When Inflation has ravaged markets in the past, real assets such as Oil, Gold, and Real Estate have generally outperformed equities and debt, offering wealth preservation even when the value of money is rapidly deteriorating.
Furthermore, inflation-indexedbondsor savings products can also help investors deal with the negative impact of Inflation.
Interest Rate vs Inflation
When inflation is persistent in the economy, the central banks need to keep raising rates to bring it under control.
A rise in interest rates slows down credit circulation in the economy, which in turn should ease inflation. On the other hand, rising rates result in result in a higher risk of default for both home and auto loans, including arecessionand ramping up unemployment.
For context, it took nine years for the US to reach the same unemployment rate after the 2008 crash, signaling the delicate nature of the economy.
Interest Rates and Bond Prices have an inverse relationship and tend to move in the opposite direction.
Say you own a bond with a face value of $1,000 and a coupon rate of 2%. If interest rates are increased, the government or corporations will issue new bonds with higher coupon rates. Let’s say the new bonds have a 3% coupon rate. Investors will want to buy them instead of your 2% bond.
Rate of Inflation by Country
Let’s look at 3 of the major economies.
Current Inflation Rate in the United States
Source: Tradingeconomics.comCurrent UK Rate of Inflation
Current Inflation Rate in the United States.
Source: Tradingeconomics.comInflation Rate of Germany
Current UK Rate of Inflation.
Source: Tradingeconomics.comInflation Year over Year
Inflation Rate of Germany.
If you are struggling to understand if this is high or low, let’s look at the Year-over-Year figures for the United States:
Source: Tradingeconomics.com
Inflation Year over Year.
As you can see, the current inflation rates are at record heights for the last 25 years.
How to Calculate Inflation
The Inflation is calculated based on the Consumer Price Index (CPI). CPI is a measure of the average change over time in the prices that people pay for a fixed supply of goods and services.
The CPI is based on data collected from thousands of businesses. These businesses report what they pay for products and services every month. The Bureau of Labor Statistics then calculates how much these companies would have had to pay if they bought the same items and services at the beginning of the year. They do this using a formula called the “price index.”
Below is how the CPI of United States for the latest 12 months looks like. It is not hard to see its perfect correlation to the inflation rate.
CPI of the United States for the latest 12 months. Source: Tradingeconomics.com
What is Deflation in Economy
What is the Difference Between Deflation and Inflation
Deflation is an economic phenomenon that affects prices, wages, and the economy as a whole. In contrast to Inflation, in deflationary times, the purchasing power of a currency unit increases because less money needs to be exchanged for goods or services.
In other words, it takes less money to buy the same amount of goods or services as before. As such, deflation creates a disincentive for companies and individuals to invest, leading to decreased economic activity in the long run.
How does deflation happen
Deflation happens when prices drop. It’s caused by a smaller money supply or less demand, or it can happen by itself. When prices drop too low, people and businesses hold onto their money instead of spending it.
Either way, the money supply decreases, which means the value of each individual dollar increases and prices go down.
Why Deflation is a Problem
Deflation seems like a good thing at first because it helps to lower prices for goods and services, but in the long term, it can cause trouble for the economy. Essentially, since deflation occurs, demand is lower, leading to companies lowering costs by cutting employees, thereby increasing the level of unemployment.
A classic example of deflation hurting investors is the phenomenon that has occurred in Japan over the last two decades. Low population growth, combined with a decline in wages, has led to a prolonged period of deflation.
While wages in the U.S. and Europe have grown between 50 and 80% over the last 20 years, they have declined by 5%. Businesses with stagnant sales due to low spending have cut prices, feeding a cycle of slow growth and deflation.
Investing in Deflation
If deflation persists for a short time, investors could look towards growth and tech stocks, fueled by low rates. However, Equities have historically underperformed in sustained periods of deflation as a result of low demand, particularly in the case of Japan since 1990.
In such cases, Bonds and other fixed-income instruments tend to outperform, despite negative interest rates from central banks due to high demand from price-insensitive buyers. Another asset that performs well, albeit with low returns, iscash.
Deflation in the US
The last technical deflation happened in US in 2015, when the inflation rate hit -0.1%. However the last true deflation happened in 2009 with the indicator hitting -2%. We all know that story.
You can identify the periods of deflation by simply looking on the inflation chart and searching for negative values.
Deflation in the US. Source TradinEconomics.com
Definition of Stagflation in Economics
Stagflation is a combination of economic stagnation, high unemployment, and severe Inflation-can cause serious difficulty for a country’s economy.
Although stagflation has rarely been documented, it occurred as recently as the 1970s, when it adversely affected the financial fortunes of central banks in the United States and Great Britain.
While stagflation is a rare scenario, there are clear parallels between the current macroeconomic state and the 1970s. This includes central banks easing markets through low rates and fiscal stimulus, governments allocating large sums of Monet to welfare programs, andcommoditiessoaring due to heightened geopolitical tensions.
What is Stagflation Caused by
The following factors could lead to the worst of both Inflation and deflation: limiting corporate growth and rising input costs. The side effects of stagflation include a sharp rise in unemployment and a continued rise in prices.
Investments in Stagflation
The best-performing asset in the 1970s was gold, which surged from $35 an ounce to nearly $700. Other assets that have historically performed well in such cases include precious metals such as silver and commodity and energy-focused equities such as Vale, Exxon, and BHP.
Stagflation of the 1970s
Until the 1970s, many economists believed in a stable inverse relationship between inflation and unemployment. Then came thestagflationof the 1970s, a combination of slow growth and rapidly rising prices.
Then,in 1973, OPEC banned the United Statesfrom exporting oil due to its participation in the Arab-Israeli war. Oil prices skyrocketed as a result. That’s the type of price shock that central banks can’t control. However, because it occurred at a time when inflationary psychology was already heightened, it contributed to the entrenchment of expectations of ever-rising prices.
Bottom Line
While the future remains uncertain, markets are currently pricing in an economic boom and increased asset prices. Markets have been trending upward since 2008, so it makes sense that investors expect them to continue doing so.
If nothing else, investors know that any deviation from this trend, such as Inflation or stagflation — could cause volatility and cause different assets, such as commodities and real assets, to come to fray.
A portfolio balanced with all three assets might be a good idea; it would include some cash for downside protection and scope to buy amid any wider selloff, even if it comes at the expense of underperforming markets in the short term.
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