Could Some Sectors Benefit from Inflation?

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Recent equity market volatility is being partially attributed to potential Fed tightening, as the Fed has signaled a shift from an accommodative monetary policy stance to one that is more restrictive. It is doing so in response to the recent hot inflation reads and a rebound in inflation expectations. In general, equities are considered a hedge against inflation. Why, then, are equity investors so concerned? The reason is that not all equity sectors are created alike. Specifically, some can combat inflation and subsequent interest rate increases better than others.

Are Equities a Hedge Against Inflation?

When inflation is low and rising, as is generally the case during the start of an economic cycle, it is good for equities. It’s the part of the cycle where an economy is emerging from a recession, economic activity is lifting, consumer demand is picking up, profit margins are rising, and loan growth is gathering steam. This backdrop is generally the most ideal for equities.

As the chart below shows, it leads to stock price gains that beat inflation 9 times out of 10. This is where we were in the second half of 2020 and for most of 2021. U.S. equity gains were strong during this period—outpacing inflation by a wide margin.

Source: Schroders

If the economy overheats, demand exceeds supply leading to much higher inflation. And if this feeds into higher inflation expectations and interest rates? Things can start to unravel for equity investors. High and rising inflation dents consumer sentiment. Consumers worry that their dollar will not go as far, and they start cutting back on spending. The costs of inputs, labor, and capital rise for companies, but they can no longer pass on these higher costs to consumers. Corporate margins are then compressed, and lower future cash flows get discounted back to the present at higher discount rates, leading to lower stock prices. The market expects that our economy is heading this way, and it’s what is scaring investors.

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