Market Update: US Inflation
The United States announced it’s February inflation numbers on Thursday, March 10th, posting the highest change in CPI (consumer price index) year over year since 1982 at +7.9%. Perhaps, the most concerning aspect of the inflation report is that this increase doesn’t include recent skyrocketing oil prices which followed Russia’s invasion of Ukraine on Feb. 24, 2022 and will be reflected in next month’s CPI numbers
Below is a breakdown of the specific consumer sectors which contribute to US inflation numbers:
Source: https://www.bls.gov/news.release/cpi.nr0.htm
This puts additional pressure on the Federal Reserve in the lead up to their meeting next Wednesday, March 16, 2022, when they are expected to raise rates for the first time since 2018 to combat rising inflation numbers.
Canada is releasing their February inflation numbers on Wednesday next week with the next rate hike meeting taking place on April 13, 2022. Currently, the inflation number is expected to be 5.4% (from 5.1% in January).
Both the Canadian and US governments find themselves in a precarious situation as inflation continues to run rampant, while at the same time an international conflict is occurring in Ukraine and economic sanctions are being levied. The war and global government responses are having massive impacts on commodity markets, which is contributing to the existing inflation as well as adding to the possibility of a global recession. If governments raise rates too quickly they could trigger a recession, but if they don’t, we could see runaway inflation further decreasing the purchasing power of both currencies.
Rock, meet hard place.
Inflation and Investing
Inflation is not expected to slow down in the near term and will most likely be higher in the coming months. It is important to be aware of which segments of the market perform well during high inflation and a rising rate environment.
The last (and only) two times US CPI crossed over 7.5% since 1960, the S&P returned -36.76% and 5.67%, while the TSX returned -32.11% and 30.52% over the next 12 months. Even though this is a very small sample, it is evident that inflation can make the return profile of the market a bit less promising than usual.
What makes things more difficult is that holding cash in a high inflationary period guarantees that you are losing purchasing power by not investing it, due to currency erosion.
Although the following asset classes may “outperform” during tight financial conditions, this does not mean that they will produce similar returns as the past few years. In turbulent markets we need to focus on preserving our capital rather than growing it.
Growth vs. Value
During periods of rising inflation there is a fundamental shift in the performance of stocks depending on their profitability vs. their market capitalization (share price multiplied by outstanding shares). Value stocks are usually found in mature industries with a history of solid performance, pay dividends to their shareholders and are relatively cheap compared to their high growth counterparts. Typical examples include banks, energy, utilities, and established retail companies. Growth companies are based upon future promises which are commonly found in the early stage tech space, these companies have low profits or are unprofitable, have a short history and experience accelerated growth in their share price, hence the name.
Growth outperforms Value in times of low inflation because of the relatively cheap cost of capital with interest rates commonly below 2% and most recently, below 1%. As inflation begins to grow, central banks respond by raising rates, thus making the cost of capital rise. This simple monetary maneuver restricts liquidity in the economy thus favoring companies with a steady flow of cash coming into the business without the requirement of reinvestment. We have been in a prolonged period of low inflation and low interest rates since the great financial crisis in 2008. Rates were briefly raised in 2018 before being lowered to 0.25% as the economy was shuttered from the COVID pandemic.
Now that we find ourselves in an inflationary environment with multiple rate hikes expected in the coming months, we could see outperformance shift from growth stocks into value.
Real Estate Investment Trusts
Although real estate is a common investment safe haven during high times of inflation, there is a broader backdrop to the current real estate market (depending on your location) of high prices, high competition and low housing supply. Purchasing property could still very well be a good investment but perhaps a better allocation can be found within Real Estate Investment Trusts (REITs).
REITs are financial trusts that own or finance income producing real estate across a range of property sectors (commercial, residential, industrial, etc.). These REITs are then traded on major stock exchanges just like Apple or Facebook. With REITs you can gain exposure to cash flow positive real estate investments without having to take out a mortgage and being exposed to rate hikes. They also offer broad exposure which can limit downside of being exposed in specific geographic locations like you would be if you purchased property.
It is important to note that although real estate performs well in inflation it can deteriorate quickly in a rising rate environment especially when rates are rising quickly.
Gold
As the price of everything rises around us, investing in commodities allows investors to have exposure to those rising prices. One of the most popular commodities to invest in is gold, it is a hard asset with a limited supply that is used by investors to protect the value of their savings while global currencies can continue to be printed by central banks. Although gold may not dramatically increase in price, it can gradually increase or hold its value over long periods of time.
Investors can also gain exposure to gold by holding mining stocks, Index ETFs and royalty companies, each with their own merits and drawbacks.
As today’s markets continue to hit turbulence and inflation continues to rise, it’s critical to have a clear and concise strategy as well as always keeping your long term goals in mind. If you have any questions about your current investment allocation or are interested in what we can offer at the Cash Management Group, please reach out to us at (604)-643-0101 or book time with us through the following link - Private Wealth | Cash Management Group
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