Inflation is up, but there could be money to make from those well-positioned companies able to pass along price increases.
This issue has gained particular urgency since the U.S. Labour Department reported last week that the country’s consumer price index – or CPI, which tracks prices paid by consumers – increased by a stunning 6.2 per cent in October over the past 12 months.
Strip out volatile food and energy items, and so-called core inflation rose 4.6 per cent year-over-year. That marked a sharp increase from September and the fastest annualized pace in three decades. It’s also a possible sign that central banks might not be able to dismiss rising inflation as a transitory threat.
The good news: Strategists are now crunching numbers to figure out the best approach for investors should inflation prove persistent.
In a report, Ian de Verteuil, head of portfolio strategy at CIBC World Markets, looked at periods of rising inflation since 2000, two decades that line up relatively well with today’s economic conditions of low unemployment and low interest rates. He defined rising inflation as a period when U.S. core CPI was one standard deviation – a measure of variation – above its two-year average for at least a three-month period.
Using this definition, there have been seven periods of rising inflation and seven periods of falling inflation since 2000, excluding today’s action.
U.S. stocks outperformed bonds during these periods in either case, but in a surprising twist the difference was far narrower when inflation was rising: Stocks beat bonds by just 2.8 percentage points, compared with a 12.5 percentage point trouncing when inflation was declining.
That’s an interesting twist, given that conventional wisdom suggests that stocks can deliver inflation protection. Mr. de Verteuil attributed the better performance of stocks in the latter case to aggressive monetary policy from central banks, which have been quick to cut rates when inflation was falling, out of fear of deflation.
“This has the effect of creating a strong correlation of stocks and bonds, but as yields were already low, stocks developed more torque to the monetary stimulus,” Mr. de Verteuil said in his report.
But in terms of sector performance within the stock market, the differences are striking. During periods of rising inflation, U.S. utilities showed by far the biggest outperformance relative to the S&P 500, beating the benchmark by an average of 13.1 per cent. Real estate stocks and consumer staples also did well.
“The logic here is that many utilities have some inflation ‘protection’ built into their pricing, and could even win in the longer term from higher regulated rates of return. We also think real estate has some ‘pass through’ mechanisms,” Mr. de Verteuil said.
Canadian sector performance was similar, with utilities, real estate, energy and industrials outperforming the S&P/TSX Composite Index by the widest margin, on average.
Conversely, when inflation is falling, technology, materials and consumer discretionary sectors were the best bets.
How much longer will the current inflationary trend persist? Based on economic forecasts from CIBC economists, Mr. de Verteuil estimates that we are only halfway through the current trend, which is now seven months old. And given that some sectors have not yet embarked upon inflation-fed rallies, investors might still be able to profit from the trend.
In particular, he recommends Canadian utilities and industrials – think along the lines of Fortis Inc., Emera Inc., and the railways – because they have been lagging the performance of the TSX during the current round of rising inflation. On the other hand, the real estate sector has already taken off.
This game plan comes with a caveat: Stock valuations are exceptionally high by some yardsticks and supported by ultralow interest rates, which may be about to rise. But the plan shows that there can be opportunities even when fundamentals are shifting.
“No two economic periods are identical, but history does tend to repeat itself,” Mr. de Verteuil said.
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