Inflation – History says don’t panic
By – Amit Vyas, Head- Products & Research – Wealth, Equirus
Lately, there have been many concerns about high inflation numbers across the world. It has been drawing attention from all the participants of economy; producers, consumers, central banks and policy makers. US Federal Reserve has been on a rate hike spree, after a decade of loose monetary policy. The guidance from US FED Reserve is that they will shrink the balance sheet in the coming quarters, specially, to tame inflation. The template for the rest of the Central bankers is likely turning out to be same. There are concerns whether this will push the US economy into recession and can there be a ripple effect on the economy and the underlying investment landscape due to tightening of financial conditions.
The impact could be seen with decrease in demand for durable goods, decrease in asset prices and spending. On the euro area front, the financial stability has worsened due to Russian invasion of Ukraine which has led to higher energy and commodity prices along with increased risk to euro area inflation and growth. As a major energy producer, Russia’s spigot of oil and natural gas to global markets is likely now to be in limbo for the foreseeable future. Those reduced supplies are already impacting oil prices, raising the cost per barrel to levels not seen since 2008. Additionally, Russia and Ukraine together produce around 1/3 of the global export of wheat, so grocery prices already high over the past 6 months will only face added pressures upward.
Back home, high inflation (CPI / WPI) continues to be a major concern as well. According to minutes of MPC, Reserve Bank of India (RBI) governor Shaktikanta Das is of the view that the Russia-Ukraine war has globalised inflationary pressures across different countries and the risk of long-term inflation expectations getting unanchored is increasing. While inflation fell in May’22 as against April’22, it has now spent 32 consecutive months above the medium-term target of 4 percent and five straight months above 6 percent upper-bound of the 2-6 percent tolerance range.
Let’s cover the effect of Inflation on broader Asset Classes and the way investments should be approached.
Inflation & Fixed Income: Returns on Fixed Income instruments are affected due to the inverse relationship with interest rates. Rising inflation is a real concern for investors holding assets that produce a fixed income stream. Inflation reduces the value of a bondholder’s coupon interest payments. The longer the maturity of the bond, the more pronounced the inflation effect. This is because there are many more coupon interest payments to come at further dates, which reduces the present value of those future payments even more. The principal or maturity value will also experience this reduction in purchasing power by the time the bond matures or is repaid.
When the inflation rate goes up the interest rates or the bond yields will also go up in tandem with the inflation. We have seen that phenomenon play out in the last 12 months where the 10 Year G-Sec yields have gone up sharply by 150 basis points in tandem with the rise in inflation expectations. When bond yields go up the bond prices will go down to ensure that the YTM of these bonds remains at around the same level. When bond prices fall, it leads to capital losses for
bond holders.
It’s therefore advisable for investors to keep the investment horizon in a Fixed Income Mutual Fund / Bonds strictly in line with the duration of the Fund. Long duration bond funds specially, should be only invested when the investment horizon is minimum 5-7 years plus. The intermittent drawdowns in the rising interest rate scenario can hurt the performance of the long duration bond funds in the short to medium term. Timing inflation and interest rate is just like timing Equity markets, easier said than done.
Inflation & Equities: The stock market helps keep up with inflation and build wealth over the long term. Let’s understand that inflation is why we invest. While we may feel caught off guard by the recent price surge, by investing in the stock market we have already been preparing for this very moment. Let’s take the long-term data of US Equity Markets, from 1914 to 2022, US inflation has averaged 3.25% annually. The S&P 500 Index, on the other hand, has had an average annual return of 10.49% from 1926 through 2021. By staying invested over the long term, the investor hasn’t just been keeping up with inflation, he has been building wealth. India is no different, Since Jan’00 – May’22 Nifty 50 TRI has given an annualised return of 12.67%. India CPI has averaged 5.89% annually in the same period.
Also, be aware that economists have long studied the connection between inflation and stock market returns. While many have concluded that inflation has a net negative impact on the markets, there does not appear to be a clear correlation between inflation and market returns, particularly in the long term. Historically, periods of high inflation have seen both positive and negative stock market returns. Many factors contribute to stock market performance, and
inflation is just one of them.
So, while we don’t want to panic in the face of inflation, we do want to acknowledge its impacts. As we’ve seen in recent months, a sudden spike in inflation can lead to market volatility. Stock prices, and stock market returns, are largely based on expectations of company’s future earnings. As inflation erodes the value of a dollar of earnings, it can make it difficult for the market to gauge the current value of the companies that make up market indexes. Further, higher prices for materials, inventory, and labour can impact earnings as companies adjust. As a result, stock prices can fluctuate, and this causes volatility.
We suggest holding existing investments which are close to your broader Asset Allocation levels. For long term investors with high equity exposure, suggest keeping some liquidity to be added on market declines over the next two quarters, preferably in a staggered manner.
Inflation & Commodities: Since inflation accounts for weighted index of prices of different goods, services – raw materials and final products, their prices are an indicator of inflation and act as a strong hedge against inflation. Commodities tend to do well under a rising inflation scenario.
From March 2020 to May 2022, the Dow Jones Commodity Index has gone up by 161% primarily due to supply side trade disruptions, export bans and Russia-Ukraine war resulting in surge in commodity prices. Back home, the commodities and proxy play to commodities sectors have gone up significantly too.
Such a surge has spurred conversations about global stagflation – an economic condition where high economic growth and unemployment coexist with rising inflation, although the risk of stagflation in India remains low due to its prudent stabilization policies.
To conclude, whilst Inflation can distort the asset prices and markets in the short to medium-term, long-term performance of various asset classes and equity markets in general, is slave to corporate earnings, GDP growth and may other factors. As a long-term investor, you could hedge against inflation and protect the value of your stored wealth by creating a portfolio spread across various asset classes. Diversification is holy grail to investing. For traders taking a short-term view, there is evidence to suggest that higher inflation also tends to lead to increased stock market volatility, creating opportunities for buying fundamentally strong businesses.
