What is the effect of inflation on trading?

Most traders around today are too young to remember the high inflation of the 1970s and the devastating effect it had on people’s livelihoods. There were several causes, including the staggering cost of the US involvement in the Vietnam War, the US withdrawal from the Gold Standard in 1971, and the quadrupling of oil prices by OPEC in 1973. Ultimately, US Federal Reserve Chairman Paul Volcker is credited with beating inflation by driving up interest rates. The cure was painful as it led to two recessions, high unemployment, and a stock market slump. However, it did the trick and inflation fell sharply, laying the foundations for strong growth over the next two decades. But what does all this have to do with trading?

Inflation in recent years

For the last 20 years or so, official inflation measures have been remarkably benign, particularly across the US, Eurozone, and Japan. Lower wages and increased productivity from globalization have helped keep inflation in check, while large financial shocks have also had a big effect. The banking bust of 2008/9 was a massively deflationary event, where asset prices collapsed and unemployment soared.

In response, the world’s major central banks hosed money into the global financial system. They slashed the cost of borrowing, with some central banks eventually adopting zero or even negative interest rates. In addition, they provided greater doses of monetary stimulus by buying government and then corporate bonds. The idea was that this extra liquidity would trickle down into the wider economy as banks lent out to businesses that would go out and spend, growing the whole economy.

But it didn’t work out like that. Rather than risk lending, banks and other financial institutions with access to cheap credit decided to hang on to these funds, instead of investing in real estate, equities, bonds, and other non-productive assets. Large corporations were also happy to take on more debt at cheap rates. But rather than looking to expand by investing this money in new employees, plant, and machinery, IT upgrades and staff training, they paid out dividends and engaged in stock buybacks. This helped drive up share prices and encourage further speculation. There was certainly plenty of inflation in global stock indices, property prices, and works of art, but none of this was picked up by standard inflation measures.

Inflation and Covid-19

What about now? The economic slump that followed the global coronavirus lockdowns was another deflationary event. Once again it was met with a package of coordinated rate cuts and bond purchase programmes from the world’s largest central banks. However, this time round governments also announced mind-boggling spending plans to shore up the economies that they shut down. The money that they are pumping into their respective economies is going directly to people whose livelihoods are at risk. Those same people have what economists call a ‘high marginal propensity to consume’. In other words, they generally spend the money they receive on essentials, so won’t be buying houses or US Treasury bonds with it. Could this be the trigger that finally sparks inflation?

Perhaps that’s no bad thing. Inflation is wonderful at reducing debt, so if it helps reduce the horrendous burden that many governments, corporations, and individuals are currently suffering, that is good news. Unfortunately, it’s terrible for savers and people on fixed incomes. Not only that, but once inflation takes hold, it can be very difficult to bring it back under control. The worry is that central banks, in particular the US Federal Reserve, will prove reluctant to raise rates as inflation picks up. In fact, there’s speculation that central banks could let inflation run as high as 4% — double their official targets — before raising interest rates to slow it down.

Inflation and trading

You can tell when investors and traders begin to worry about inflation by the movements of certain markets. Investors look to dump a depreciating currency by buying up hard assets. Precious metals and other commodities become increasingly popular, while property prices generally keep abreast of inflation. It can be a mixed picture for equities. Recently, we saw stock markets perform well in countries that have had episodes of high inflation or hyperinflation, even if ultimately, they couldn’t fully keep up. For example, Zimbabwe’s currency was crushed but its stock market soared. Some sectors fare better than others and companies that can pass along higher prices are generally doing well.

For individuals, their disposable income is squeezed by rising prices, meaning they must consider the importance of purchases. In the past, certain sectors have been resilient or even prospered in times of rising inflation. Pharmaceutical companies, miners, and consumer staples can all do well, for instance. They provide goods and materials that are vital for modern-day living, and in most cases, can pass on increased costs to their customers. Utility companies can be relatively safe too. For a start, the demand for water, electricity, and gas is relatively inelastic. Also, they require significant infrastructure to operate. While this is expensive to maintain, it also means there are large barriers for would-be new entrants to the market. Highly regulated, large utility companies should be fairly resilient in the face of inflationary pressures.

Although it may be relatively easy to identify companies and commodities that should do well during periods of inflation, it’s more difficult to guess how central banks will react. After all, if wages keep pace with inflation, most people are happy to start with. But once the inflation genie is out of the bottle, it can be very difficult to control. That’s when central bankers must bite the bullet and push up the cost of borrowing, and that’s rarely a popular decision. Time will tell who will face the same opprobrium as Paul Volker did forty years ago.