The baseline of inflation: what does inflation mean for stocks?

What is Inflation?

Inflation is a term that we have all heard about in the news recently, it’s a substantial element to consider over the next few years. In a nutshell inflation can be explained as a process: As a currency loses value the prices of goods and services increase which then impacts the cost of living, and ultimately leads to a slowdown in growth. The generally accepted definition varies a little but when money supply exceeds economic growth you have inflation. It is a crucial component of measurement for central bankers and provides a single representation of estimated value or purchasing power.

Figure 1: inflation – when prices rise but the value of one dollar falls.

How do we control inflation?

In order to combat the slowdown in growth, central banks try to manage the total money supply within the domestic economy. This is done to try and keep the inflation numbers within tolerable limits, not an easy task when we consider the current circumstances based around stimulus packages globally. Now that economies are beginning to remerge seemingly in control of COVID-19 and the vaccine rollouts while the stimulus checks continue to get posted out, inflation has become the topic of choice.

Inflation and Bonds

While the headline says we are looking at inflation versus stocks, its important to understand the relationship between inflation and bond yields. It’s not a kind and loving relationship, its inverse. Inflation is effectively the bond villain to the 007, they counter act one another, as inflation rises the purchasing power of a bonds future return degrades, meaning bond investors chase higher and higher bond yields to accommodate for the rising inflation risk.

When we take a step back and consider the rising yields in global 10-year bonds (predominantly Australian and US 10-years) from last week, it shows that investors were demanding more in yield inline with the rise in inflation expectations. Obviously, the RBA has stepped in doubling monthly purchases to $4 billion, Which slumped the 10-year Aussie bond quickly.

Now while rising yields and inflation can be a good thing, its only when inflation can be controlled and gradual. Should rapid increases occur it doesn’t allow the other areas of the economy to absorb the changes, usually the first noticeable symptoms to the everyday citizen is the rapid increase in borrowing costs.

Inflation and Stocks

Provided the inflation remains gradual and is accompanied by yields at a similar growth trajectory its not so much of a problem, but volatility in bonds is something to be feared. If yields suddenly rise forcing a repositioning, then stock prices will see harm. The simple reason why is that if the unit of measurement ‘being money’ suddenly shifts its value then the valuation of stocks becomes difficult. The time value of money related valuation methods generally requires the bond yield as a discount rate, if the yield rises, then the higher the discount rate input and the lower the present value. If we used an alternative valuation technique such as price to earnings, it still results in the discount rate affecting valuations inversely to the rise in yield. The higher that PE ratio is, the more sensitive to yield changes the stock will be, this is due to present values being derived from expected earnings and not actual earnings.

What about my portfolio?

The need to track inflation has become a much-needed focus of those invested into financial markets, particularly those with high exposure to the tech sector where we can see some of the higher PE ratios. But with low wages, low rents, and $4 Billion per month in bond purchases and a floor of sorts set by the Reserve bank of Australia, it becomes a positive, slight but still positive.

In my book, for Australia, while inflation does carry some concern there is little risk of persistent rapid climbs in inflationary figures. And I’m not certain we can fully discount the idea of spikes in inflation and yield from occurring, when baseline figures having sat so low for so long.

What I am certain of is that inflation and yields will be the theme for the next few months to years ahead.