The US Consumer Price Index (CPI) rose 5.4% year-on-year (YoY) in this June, the highest YoY increase since August 2008[1]. Looking ahead, as countries continue to reopen with consumer demand picking up steam, global inflationary pressures look set to flare up. How will higher inflation affect various assets, are such rises only transitory, and how should investment decisions be made in an inflationary environment, are among the issues central to global investors’ future allocation strategies.
The extent to which equity valuations are subjected to the effect of inflation is enormous. Historically, moderate inflation rates were conducive to the stock markets. But during periods of subdued inflation, deflation could be a concern for investors. Deflation shrinks corporate profits and heightens the likelihood of bankruptcy as the overall level of debt would rise in value, increasing the risks of bankruptcy in financial companies and economic recession. But when inflation runs too hot, so does volatility. Under such an environment, budgeting costs would become difficult, leading to reduced capital expenditures and, eventually, stifling economic growth.
Within the equity space, there are areas that are more sensitive to higher inflation rates. Investors would do well to familiarise themselves with the concept of “duration”, a term commonly used by bond investors. Simply put, duration means that the longer it takes to realise the cash flow of a bond, the more sensitive its price is to changes in interest rates. For example, a five-year zero-coupon bond – whose principal and interest will only be returned in one lump sum at maturity – will see its price fall more drastically than a five-year bond that pays dividends every six months when the interest rate rises. The price of a 20-year bond will therefore be more volatile than a five-year bond.
If we apply the same principle of “duration” to equities, when inflation flares up, heightening the risk of interest rate hikes, the longer the duration a stock has, the harder its price will drop. Which ones belong to the long-duration category, you ask? Generally, those that are still in the investment phase and have yet to generate positive cash flows can be classified as long-duration stocks, such as the listed shares of some tech companies whose balance sheets are still in the red. This also explains partly why some tech stocks fell more heavily recently than the market average.
Another question investors have to ask themselves is, is the rise in inflation we see today just transitory or structural? Investors in the “transitory” camp attributed price rises to the US government’s unprecedented economic stimulus measures. Moreover, comparing inflation rates on a “year-on-year” basis means that the low-base effect is at play here. As the economic stimulus moderates next year, money supply should also slow down to single-digit growth, with inflation subsiding to acceptable levels as a result.
And in the perspective of those in the “structural” camp, the widening ideological divergence between China and the west could hinder the flow of global trade and cause inflationary pressures to pile up. While countries including the US, Europe, and Japan all unleashed quantitative easing measures after the global financial crisis, these unconventionally loose monetary policies did not accelerate inflation growth. One of the key reasons was that, riding on the wave of economic globalization, cheaply manufactured products from China and other Southeast Asian countries flooded the markets overseas and drove down prices. Having said that, global trades as a share of global GDP have been declining since 2008, with the levels seen in 2019 treading lower than that of 2014[2]. Given that the pace of deglobalization has quickened after the Covid-19 crisis, investors who believe that the higher inflation is structural are naturally reassured that there may yet be more challenges in keeping global inflation in check.
[1] Source: Wall Street Journal, as of July 2021
[2] Source: the World Bank, as of July 2021
Disclaimer
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