How Will Inflation Dictate The Actions Of Traders And Investors?

Throughout the COVID-19 pandemic, governments and central banks have been left with little other option than to deploy unprecedented quantitative easing and levels of financial support to boost the economy.

While many of these efforts have proven successful, with the UK economy now growing at the fastest rate in 80 years according to some estimates, efforts to restimulate the market have come as something of a double-edged sword for investors. 

Right now, inflationary pressures are becoming apparent on both sides of the pond, as the release of data in June showed that US consumer prices increased by 5% in the year up until May. At the beginning of August, inflation had overshot the Bank of England’s (BoE) forecasts for three successive months, and although it seems like some respite is on the horizon, ex-BoE chief economist Andy Haldane has voiced his doubts over the central bank’s actions to keep inflation in check. In the face of dovish thinking, Haldane was the only member of the monetary policy committee to vote in favour of tighter policy, in order to head off the threat to price stability. The BoE has suggested that UK inflation will top 4% by the end of the year, well above its original estimates. As such, some might wonder whether we are in for an era of much higher inflation, and potentially even a wage-price spiral. Whatever your position on monetary policy, traders and investors will naturally be concerned about how they should act in response to these developments. Here are some considerations to bear in mind.

Keeping an eye on inflation

First thing’s first, traders and investors should keep a close eye on central bank statements before taking any drastic action. For example, any dissenting views from key figures, or signals that the bank is set to raise interest rates and tighten monetary policy, can offer insight into the bigger picture, and the general outlook for inflation going forward. But beyond reading between the lines of these statements, there are some regularly reported measures of inflation that investors should be monitoring.

In the US, the Consumer Price Index (CPI), which reflects retail prices of goods and services, including housing costs, transportation, and healthcare, is the most widely followed indicator. That said, it is important to note that the Federal Reserve also emphasises the Personal Consumption Expenditures Price Index (PCE), which covers a wider range of expenditures. Meanwhile, in the UK, the official measure of inflation is its own Consumer Price Index (CPI), or the Harmonised Index of Consumer Prices (HCIP). 

Wherever you are in the world, central banks will have their own target rate of inflation. As such, traders and investors would do well to bear this in mind, given that protracted periods of high inflation pose a stealth threat to investment returns. Rising inflation in New Zealand, for example, has been enough for the Reserve Bank of New Zealand to project an interest rate hike this year and four hikes in 2022. This was when inflation spiked above the 1-3% target hitting 3.3% year on year. 

Investment options as a hedge against inflation

If investors do not protect their portfolios accordingly, inflation can be detrimental to fixed income returns, such as bonds. However, the effects of inflation can vary across sectors.For starters, the merits of gold, commodities and property must be carefully considered in an inflationary environment. While none of these assets are a perfect antidote to the inflation conundrum, they do offer a degree of portfolio protection.

In terms of commodities and precious metals, historically, the mantra that ‘gold is a hedge against inflation’ needs some careful consideration – if this were the case, then surely its price should hardly ever fall. Because gold gives no interest in holding it, investors tend to sell gold in order to buy riskier assets at the first sign of stronger global growth, and this is something to bear in mind. But so long as interest rates remain low, this is good for gold. 

By contrast, assets like growth stocks, including big tech and value stocks, might be less attractive. This is because higher inflation tends to impact the future profitability of these companies. As growth stocks have much of their earnings expectations in the future, this means that when rates rise, this damages these expectations.

On the contrary, inflation can actually be beneficial to some asset classes. As mild inflation is often a sign that the economy is growing, this means that businesses can raise prices, which in turn can stimulate job growth. For instance, a look at the S&P 500 returns historically and adjusting for inflation shows that an inflation rate of 2% or 3% is often a sweet spot, offering the highest real returns.

With this in mind, it is important to add that value stocks, which have a higher intrinsic value than their current trading price, will often outperform growth and income stocks. Value stocks frequently constitute mature and well-established companies with strong current free cash flows that may diminish over time, but this will largely depend on whether the investor in question is taking a long- or short-term view of the market. 

For those taking a short-term view of the market, some evidence suggests that higher inflation also tends to lead to increased stock market volatility – consequently, this creates fresh opportunities for either buying or short-selling stocks. Yet, it is vital to remember that the stock market is cyclical – while the bad times may hit investors hard, they will not last forever, and there is much to be gained from staying invested for the long haul.

Although central banks remain defiant that inflationary pressures are transitory, the bottom line is that inflation has arrived. Traders and investors will need to weigh their options carefully when determining their activities.

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About the author: Giles Coghlan is Chief Currency Analyst, HYCM – an online provider of forex and Contracts for Difference (CFDs) trading services for both retail and institutional traders. HYCM is regulated by the internationally recognized financial regulator FCA. HYCM is backed by the Henyep Capital Markets Group established in 1977 with investments in property, financial services, charity, and education. The Group via its relevant subsidiaries have representations in Hong Kong, United Kingdom, Dubai, and Cyprus. 

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