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Inflation cheat sheet: How to invest when inflation is high
Summary
Quick answers to some of the most common inflation questions, including how investors can fight inflation.
Look for active opportunities following the Fed’s hawkish move
Summary
The US Federal Reserve has raised its benchmark interest rate against a backdrop of high inflation and concerns about the geopolitical situation stemming from events in Ukraine. While markets have previously taken rate-hike cycles in their stride, this time could be different, as the Fed seems to be more hawkish than initially expected. Investors should actively seek out relative-return opportunities.
Key takeaways
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Click the icons below for quick answers to some of the most common inflation questions.
3 factors pushing inflation up over the short term
4 factors pushing inflation up over the long term
What’s good
about inflation
Some inflation is a good thing for economies – and for equity valuations
- A healthy economy grows at a sustainable rate, and inflation is a typical by-product of economic growth.
- A moderate amount can also be good for the stockmarket, largely because reasonably higher prices can lead to higher earnings for companies.
- We found that for the S&P 500 Index, the highest equity valuations were observed for inflation rates of between 2% and 4 %. But when inflation is beyond 5% or so, we tend to see lower earnings and lower levels of consumption overall.
- However, these high valuations (and higher inflation) have followed years of very “loose” monetary policy from central banks. Central banks are now are determined to take action against inflation, which may put pressure on valuations as well.
What’s bad
about inflation
Even a small amount erodes purchasing power
- A 3% inflation rate can reduce the value of an asset by nearly 25% in just 10 years.
- That’s why inflation has been called a “stealth threat” to portfolios.
Effect of 3% annual inflation rate on initial EUR 100,000 hypothetical investment
Source: Allianz Global Investors. Hypothetical example for illustrative purposes only.
Consider inflation-hedging assets
- Inflation-linked bonds – such as Treasury inflation-protected securities in the US and gilts in the UK – directly benefit from rising inflation expectations, since they are designed to help protect investors from inflation.
- An active fixed-income investor can seek returns regardless of the inflation environment – which is critical given the uncertain inflation outlook.
- Equities have historically provided good returns when inflation is moderate – in part because reasonably higher prices can lead to higher earnings
for companies, and investors tend to pay more for earnings growth. - During periods of higher inflation, commodities and gold have historically done very well.
- Institutional investors may want to consider private-market assets to hedge against – or even benefit from – a sustained return to inflation.
- Base effect: term sometimes used when measuring inflation. When comparing two points in time, if the inflation rate is unusually low at one end (the “base”), even a small rise can appear to be an outsized increase in the inflation rate.
- Behind the curve: term used to describe when central banks deliberately do not raise interest rates fast enough to head off inflation.
- Break-even inflation rate: the sum of the expected inflation rate and the inflation premium. Signifies the average inflation rate where an investor would achieve the same return from either a) receiving the fixed average inflation rate or b) receiving the actual inflation as a variable cash flow.
- CPI (consumer price index): usually refers to headline CPI, also known as headline inflation. This is a key inflation metric for the US and UK, among other regions. Refers to the full hypothetical “basket” of goods and services vs core CPI/core inflation. Because headline inflation is volatile, it is considered not very predictive over the short term.
- Core CPI (consumer price index), core inflation: calculated by subtracting volatile food and energy prices from headline inflation.
- CPI-U (consumer price index for all urban consumers): measures the average change over time in the prices paid by US urban consumers for a market “basket” of consumer goods and services.
- Deflation: when inflation falls below 0%.
- Disinflation: when the rate of inflation falls, but doesn’t go into negative territory.
- Expected inflation rate: represents market participants' expectation of the average yearly rate of inflation – ie, the change of the underlying price index.
- HICP (harmonised index of consumer prices): CPI as calculated in the European Union (EU). Types of HICP include MUICP (the monetary union index of consumer prices, covering the euro area); EICP (European index of consumer prices, for the whole EU); national HICPs (for each of the EU member states); EEACIP (European Economic Area index of consumer prices): an additional HICP index for the European Economic Area (EEA) that covers the EU, Iceland and Norway.
- Hyperinflation: a disruptively rapid rise in inflation, generally more than 50% per month.
- Inflation expectations: the expectations of consumers and businesses on the future rate of inflation. High inflation expectations can actually push inflation up.
- Inflation risk premium: the compensation for unexpected inflation or deflation. It is similar to an insurance premium against unexpected moves.
- Loose/easy monetary policy: economic shorthand for how central banks expand the supply of money (via low rates, asset purchases and more) to stimulate economic growth. Also known as expansionary or accommodative monetary policy.
- Money supply: measures an economy’s supply of cash, liquid bank accounts, long-term deposits, etc. When the money supply outpaces economic output, inflation generally follows because there is more money chasing the same amount of goods and services.
- Nominal: before inflation is factored in (as in nominal yield, nominal growth rate, etc).
- Output gap: the spare capacity in the economy – the difference between actual growth and potential growth. In recent years, the global economy was operating below its full potential, so the output gap increased. This is typical during economic slowdowns or recessions. Now, the output gap is shrinking.
- PCE: the price of goods and services consumed by all households, and by nonprofits serving households. PCE has tended to be lower than CPI.
- Real: after inflation is factored in.
- Reflation: when deflation stops or reverses.
- Stagflation: a period of high inflation, slow economic growth and high unemployment.
- Wage share: the portion of economic output that gets paid to workers in the form of compensation.
- West Texas Intermediate crude oil (WTI): one of the standard ways to track oil prices.
1. Source: Bloomberg. Data as at December 2021. Consensus data reflect estimates for average inflation in a full calendar year.
They are not directly comparable to current inflation readings.
2. Source: Bureau of Labor Statistics. Data as at December 2021. Current inflation figures reflect year-on-year rates for the latest (single) month.
3. Source: Marketwatch. Data as at January 2022.
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Information herein is based on sources we believe to be accurate and reliable as at the date it was made. We reserve the right to revise any information herein at any time without notice. No offer or solicitation to buy or sell securities and no investment advice or recommendation is made herein. In making investment decisions, investors should not rely solely on this material but should seek independent professional advice. However, if you choose not to seek professional advice, you should consider the suitability of the investment for yourself.
Investment involves risks including the possible loss of principal amount invested and risks associated with investment in emerging and less developed markets. Past performance, or any prediction, projection or forecast, is not indicative of future performance. This material and website have not been reviewed by the Securities and Futures Commission of Hong Kong. Issued by Allianz Global Investors Asia Pacific Limited.