Fundamental Investing Under Inflation, an Introduction
Why do we have to care about inflation?
The majority of the world has been facing extremely high inflation since the recovery from Covid-19 began. In the US, the inflation rate is 8.2% until 22nd September 2022. According to the September employment report, employment in the US is strong and it is expected that the unemployment rate will keep falling, the unemployment rate dropped to 3.5% from last month's 3.7%, average hourly earnings also rose, increased by 0.3% from August and 5% from last year. Federal Reserve has been raising rates rapidly this year to combat the increasing inflation, given the strong employment report, economists predict that the American central bank is on track for another rate hike, and investors expect that Federal Reserve would raise the rate by another 0.75 points next month. For other countries, Euro Area is with an inflation of 9.9%, the from the latest data, UK inflation has met 40-year high to 10.1%. Although many countries have been facing severe inflation, there are still countries with relatively low inflation rates, for example, China (2.8%) and Japan (3%). So, when making investment decisions regarding inflation, we need to consider the situation in different countries.
Understanding Inflation in the Context of Differentiated Asset Classes
So how inflation and interest rates can affect different asset classes and decision-making for investment? There is no absolute thing in the world, so inflation can be good and bad for different people and in different situations. For equity markets, the relationship between inflation and stock prices is not straightforward, but there is still guidance that could help us analyse it. Interactive Brokers' analysts have once claimed that equity shares can be a hedge against inflation in long run because money is losing value due to inflation but the value of shares could appreciate with inflation, therefore, store the real value. However, stock prices are often negatively correlated with inflation rates in short term, that is, stock prices would fall when inflation is high, and prices would rise when inflation is low. S&P 500 in the US has been losing almost 20% this year and FTSE 100 in the UK has been decreasing by about 10%. For fixed-income assets, there is a theory—Inflation Expectations that can explain how inflation affects fixed-income assets, especially bond yields. In this theory, it is stated that future inflation will erode the value of the money used to repay debts, the market will then take into account expected inflation when setting current interest rates. Yield curves for bonds are about nominal interest rates, to cover it in a simple way, the Fisher equation shows that the nominal interest rate is the sum of the real interest rate and expected inflation rate, so when the inflation becomes higher, the rates of bonds would increase and therefore results in an upward sloping yield curve, indicating that investors demand a higher yield to compensate inflation. Another asset class we need to notice is gold, which is always regarded as a safe haven asset. Unlike money, whose value is determined by factors such as inflation and money supply, gold's value is derived from its scarcity as a commodity, and it has a long history of being used as the medium of exchange, so the price of gold would rise when the economic condition is uncertain and inflation is high. But it is interesting that the gold price didn't rise as inflation all the time this year. The gold price peaked in March above $2000/oz, but it then has been decreasing while the inflation has been sustaining. There is no exact analysis of this phenomenon but I think it could be that investors may believe the inflation would not sustain in long run, or it could also be that investors want to sell gold to realise their profits.
Implications to Portfolio Analysis
After analysing how different asset classes are affected by inflation and interest rates, we now need to consider how to allocate them to form a portfolio that can deliver the best performance. For different investors, we should tailor the specific portfolios for them. For investors looking for long-term returns, we need to give more weight to asset classes that could beat the market in long-term, and long in stocks of companies from highly growing industries, for example, electronic vehicle producers and related industries, although they are considered to be overvalued currently, they will still be growing in long-term and attracting most resources and capital. What is more, it may also be a good time to buy gold, because some investors sold gold to realise profits so it may be an opportunity to buy at a good price. For investors looking for short-term returns, we should reduce position in equities as they are predicted to gloom in the current period, however, we can give more weight to fixed-income assets, as they are expected to provide higher yields.
In conclusion, inflation and interest rates have hugely affected the global economy and financial markets. To make a successful investment in such a situation, investment strategies should be modified, and different investment strategies should be applied to different kinds of investors. But it is still uncertain how the markets will perform in the future, there is no exact prediction. What we can do is to best estimate them and be prepared with appropriate strategies.