Inflation occurs when prices of goods and services go up across an entire sector over a significant period of time. In the minds of investors, the effects of inflation reduce the perceived present value of future cash flows from stocks. Stock prices, at least in the short term, are largely a function of investor expectations, and if they perceive the present value of future cash flows to be lower, they will act in a way that makes them lower. As a result, stock prices drop.
Consumer Price Index (CPI)
The most widely used measure of U.S inflation is a rate called the Consumer Price Index, or the CPI. The Consumer Price Index (CPI) measures the change in prices paid by U.S consumers for goods and services. It is a key way to measure changes in purchasing trends and inflation. However, this index does not include prices of energy and food. This is because energy and food prices tend to fluctuate far more dramatically than other goods and services. The U.S Bureau of Labor Statistics publishes a schedule of monthly release dates for the Consumer Price Index (CPI) and associated data on consumer inflation. A higher-than-expected reading should be taken as positive/bullish for the USD, while a lower-than-expected reading should be taken as negative/bearish for the USD. Let’s have a look at the CPI data for 2022:
| CPI Release Date | U.S | Actual | Forecast | Previous | 2022 |
| Nov 10, 2022 (Oct) | (Latest) | 7.7% | 8.0% | 8.2% | |
| Oct 13, 2022 (Sep) | 8.2% | 8.1% | 8.3% | ||
| Sep 13, 2022 (Aug) | 8.3% | 8.1% | 8.5% | ||
| Aug 10, 2022 (Jul) | 8.5% | 8.7% | 9.1% | ||
| Jul 13, 2022 (Jun) | 9.1% | 8.8% | 8.6% | ||
| Jun 10, 2022 (May) | 8.6% | 8.3% | 8.3% | ||
| May 11, 2022 (Apr) | 8.3% | 8.1% | 8.5% | ||
| Apr 12, 2022 (Mar) | 8.5% | 8.4% | 7.9% | ||
| Mar 10, 2022 (Feb) | 7.9% | 7.9% | 7.5% | ||
| Feb 10, 2022 (Jan) | 7.5% | 7.3% | 7.0% | ||
| Jan 12, 2022 (Dec) | 7.0% | 7.0% | 6.8% |
Let’s look at the latest CPI data, just to try and understand how inflation data affects the stock market.
The latest CPI release was on Thursday 10th November 2022, when the October inflation rate stood at 7.7%, a slowdown from September’s 8.2%. The US inflation data was lower than the forecast of 8.0%, which sparked a massive rally in global stock and bond markets. Optimistic investors read the data as a sign that the Federal Reserve’s interest rate hikes are already having the desired effect of taming inflation. This, in turn, sent US and European indexes up – with the S&P 500 rising 5.5%, the Nasdaq 100 rising 7.5%, and the Stoxx 600 rising 2.8% on the day.
Some of the top gainers were rate-sensitive sectors like tech, real estate, and consumer discretionary. Stock prices don’t tell us about the state of the economy: they tell us more about the state of investors and markets. Thursday’s price reaction was interesting because it showed just how negatively investors were positioned and because it revealed the potential risks to the upside: a little positive news is enough to drive an outsized price reaction.
Let’s now look at a comprehensive diagram of how various stock categories performed on Thursday after the CPI data release:
How to Respond to Inflation
Inflation should cause investors to consider – or reconsider – both their investing style and the specific types of securities in their portfolio.
Value Investing
The investment style that tends to do relatively well during inflation is value investing. Unlike growth investing, value investing entails the practice of identifying and buying stocks whose intrinsic value, as determined by fundamental analysis, significantly lags behind their share price. Value stocks often have a relatively low price/earnings ratio and strong free cash flow.
Inflation Hedges
Besides opting for a value investing style, there are several types of securities that make wise inflation hedges. They include small-cap, dividend growth, consumer staples, financial and energy are showing up on many recommended lists. Also getting the thumbs-up are industries experiencing post-pandemic rebounds, particularly, travel, leisure, and hospitality.
Real estate is another tried-and-true inflationary hedge. Residential real estate, in particular, is seen as a haven for 2022. Home construction and building materials are also getting recommended as inflation-busters. Real estate investment trusts (REITs), public companies that own real estate or mortgages, offer a way to invest in real estate without actually buying properties.
An investment in commodities may be one of the most powerful inflation hedges. Raw materials and agricultural products can be traded like securities. Commodities traders commonly buy and sell gold and other precious metals, oil, natural gas, grain, beef, and coffee, among others. Investors can direct portions of their portfolios into commodities using futures and options contracts and through investments in exchange-traded funds (ETFs) and mutual funds.
The Bottom Line
In inflationary times, value investing is often preferred to growth investing due to lower risk, lower share prices, and dividend income. Value stocks tend to perform better in an inflationary environment while growth stocks may exhibit superior performance in a low-interest rate, low-inflation situation. Combining value investing with picking inflation-resistant securities is a wise course of action.
HAPPY TRADING!!
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