Just a year ago, the global economy was upended. Inflation shot up due to sharp rises in oil prices and supply chain breakages brought on by government lockdowns. But as markets now rally against the coronavirus pandemic, investors will pay close attention to how their earnings perform against the new economic backdrop.
Although the European Central Bank had targeted a Consumer Price Index of 2% in 2021, most analysts expect it to be around 1.5%. Currently, it is estimated that inflation this year will hover around 2.8%. This is significantly below last year’s figure of 3.2%. But inflation has many faces, depending on the equity variables in play.
What happens to equities during inflation and hyperinflation?
For starters, it’s safe to say that companies’ revenues will increase as a result of higher selling prices. However, profits may fall if these high prices drive costs of production higher. On the other hand, if all other factors are constant and real bond yields are higher during a period of inflation, discount rates rise, meaning future cash flow valuation will be reduced.
Research shows that 9 times out of 10, equities are fireproofed against inflation if it has been low (below 3%) and rising. This is the case as we speak. But when inflation is higher than 3%, the performance of equities is almost left to chance.
Generally speaking, growth stocks thrive when inflation is low. Value stocks, however, perform better during periods of high inflation. It is also believed that the prices of income-oriented or high-dividend-paying stocks fall as inflation rises. Let’s take a closer look at which stocks perform better or worse during moderate and hyperinflation.
How do sectors perform at different inflation levels?
There’s a general consensus that stocks of long-established firms are always a safe bet. Even though they struggle to pick up the pace during economic recovery, they are known to provide investors with better risk-adjusted returns.
Firms in the oil and gas sector are reported to overcome inflation 71% of the time while giving investors an annual real return of 9.0% per year on average. This comes as no surprise because stocks in the energy sector are linked to oil prices which themselves play a key role in inflation figures.
Equity real estate investment trusts (REITs) are also fairly robust against rising inflation. 67% of the time, equity REITs outperform inflation with an average real return of 4.7%. This is not incidental too because equity REITs normally create some level of inflation hedge since they own real estate assets.
On the contrary, mortgage REITs typically perform horribly in the middle of high inflation. This is because of the fall in the value of their coupon payments as inflation increases. In the end, they have to compensate for this drop with higher yields and lower prices.
Similarly, IT stocks are normally hit hard by high inflation. The reason is that many of their cash inflows are projected to arrive in the long term. When inflation goes up, these returns may be valued far less as discount rates rise.
With the financial sector, there are mixed feelings. The cash flows in the financial sector are typically short term, making them perform much better than IT stocks. However, hyperinflation is detrimental for banks because it causes a loss in the value of existing loans.
Gold is normally regarded as a hedge against currency debasement. But firms in the gold and precious metals mining sector normally post an average real return of 8.0% when inflation is high.
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