If we track the correlation between inflation and stock values, we can distinguish shares that are the best choice in inflationary times
We normally discuss inflation in connection with national fiat currencies. Everyone knows that when a currency loses its value, it deeply affects national economies. Yet, stock markets witness the outcomes of inflation too.
What does inflation mean for stocks and investors?
Inflation is the decline of purchasing power of a certain currency. It happens because of a sustained increase in the price of goods and services. As everything continuously gets more expensive, the same amount of fiat can buy you less now than it did just a month/week ago.
As a result, investors may want to convert their cash into securities or alternative assets. This strategy can serve as a hedge against losing wealth if the portfolio is well-thought-out. Meanwhile, companies that are listed on public markets may temporarily see their profits and revenues fall during inflation. It happens since their clients lose buying power. Investors thus gain lowered, or even negative, real returns and dividends.
When it comes to the stock market, traded assets may react to the rising inflation in different ways. As a rule, stock prices become highly volatile during such periods. Real returns dramatically fall. The precise market reaction depends on macroeconomic circumstances, the government’s monetary policy, the nature of stocks, and the pace of inflation. For example, stocks react much more negatively to inflation when the economy is contracting or in a recession than when inflation happens as the economy is expanding.
Thus, when the inflation rate is steady, share prices usually rise in proportion to the price level to maintain a constant ratio of share prices to real earnings. The stock market anticipates a certain amount of inflation each year and adjusts the expected returns accordingly. However, when inflation is unexpected, equity returns generally respond negatively. Higher inflation also reduces customers’ expectations of earnings growth, decreasing stock prices.
Which stocks to buy during inflation
To begin with, we should recall the common types of shares listed on public markets. Those are:
- Value stocks – publicly traded companies trading for relatively cheap valuations relative to their earnings and long-term growth potential
- Growth stocks – companies expected to grow sales and earnings at a faster rate than the market average
- Common stocks – give shareholders voting rights, usually at one vote per share owned
- Preferred stocks – does not give shareholders voting rights
- Domestic stocks – stocks of your home country companies that operate domestically
- International stocks – stocks of foreign companies or global conglomerates
- Dividend/non-dividend stocks – distribute/don’t distribute a portion of the company’s earnings to investors on a regular basis
- IPO stocks – shares of a private corporation offered to the public in a new stock issuance
- Large-/mid-/small-cap stocks – companies divided by market capitalization
- Blue-chip stocks – well-established, reliable companies with advantageous positions in their markets
- Penny stocks – issued by small public companies that trade at less than $5 per share
- ESG stocks – companies with strong environmental, social and governance values
- Cyclical/non-cyclical stocks – stocks which price is affected/not affected by macroeconomic or systematic changes in the overall economy
- Safe (low-volatility) stocks – their price remains pretty stable over long period
The type of stock matters as inflation affects them differently. For instance, growth stocks are impacted much worse than value stocks. Income-generating stocks fail to keep up with inflation rates too. At the same time, they provide a partial hedge against inflation, if the real returns remain positive.
Overall, value, small-caps and low-volatility stocks tend to perform best during periods of high inflation.
Let’s discuss each share type in detail.
Value stocks belong to mature, well-known companies that have a stable industry position and a reliable business model. Such companies have healthy balance sheets, strong earnings and low debt. Many of them are blue-chip stocks.
At the same time, their stock price is low compared to earnings. Value shares are often considered risk-free and suit conservative investors. Bold investors who seek large potential returns may not favour value stocks as the represented companies have little room for growth.
However, when you deal with inflation, value stocks perform the hedging function. Well-established quality companies were less sensitive to inflation and outperformed the global sharemarket, as measured by the MSCI World Index and other studies, in all inflationary scenarios. Their reliable business model allows quality companies to withstand inflation, recessions and other economic downturns with minimal losses.
Some examples of value stocks are Johnson & Johnson, Berkshire Hathaway, Procter & Gamble, Philip Morris, Walgreens Boots Alliance.
Small-caps stocks refer to the companies with the smallest market caps (the total worth of all their shares under $2 billion). Such stocks still have some room for growth unlike large-cap ones. They do especially well when the economy recovers, which is when inflation expectations rise. Their corporate earnings often grow faster when inflation is higher when it indicates people are spending and the economy is growing. Moreover, small-caps perform better in the long-term investment scenarios.
Among these shares, one may easily find inexpensive securities with little debt that generate ample free cash flow. There are also capital-light businesses with a history of increasing their dividends. These attributes have historically proven effective in inflationary periods.
Smaller companies in niche markets may be also better positioned to cope with rising prices, especially in consolidating industries. In the latter case, customers have fewer alternatives to choose from, so the businesses strive despite higher pricing. Think about small companies that produce specific automotive parts that are crucial for larger businesses. In addition, investors may focus on smaller companies that can pass their rising product costs to customers. It helps even small businesses to withstand inflation. Thus, B2B models may have advantage at inflationary times.
However, investors should be careful before buying penny small-caps stocks. There are often objective reasons why the shares are sold at such a low price. Businesses that sell securities at minimal prices are often young startups that have little experience in dealing with inflation. Although penny stocks may have a great long-term potential, they are highly speculative too. If you decide to buy one, make sure to check the background and financials of the company you invest in.
Low-volatility (safe) stocks
Low-volatility stocks have little or no reaction to economic changes. This happens when companies sell essential products or services and have a healthy competitive edge over their competitors. Check the corporate financial statements. Look for companies that grow their revenue and dividends steadily year after year. Nevertheless, remember that stock that’s 100% safe doesn’t exist, especially in such an unpredictable global crisis we’re still coping with. Allow for some imperfections.
When you’re looking for low volatility, consider businesses that are non-cyclical in nature. Cyclical companies are very sensitive to economic changes. They typically perform well in expansions and worse during recessions. At the same time, when the inflation is a result of rapid economic growth/rebound (like it happens now) cyclical companies are not that bad too. They sell products and services people refused or had no need to buy during the pandemic hardships. Now, as the economies rebound and citizens regain their purchasing power, they may consider an opportunity to buy cyclical goods even despite the rising prices.
When the local economy is unstable, adding stocks from countries where economies behave differently to your portfolio might be a good idea too. The easiest way to add some foreign exposure to your portfolio is through a fund. Otherwise, you’ll have to learn a great deal about foreign economies besides getting awareness of individual companies.
Global companies that operate across many regions are also usually well-protected against inflation influence in separate countries. They can manage the cash flow and assets more flexibly.