Just when investors were ready to put their incessant focus on inflation behind them, the latest U.S. consumer price report dashed their hopes. More importantly, it begs the question we’ll address here, namely: can stocks actually benefit from inflation going forward? In other words, can you use stocks as an inflation hedge?
The latest consumer price index (CPI) for the month of June showed that inflation rose 2.7% year over year, which shocked many investors since it exceeded the Fed’s goal of 2%. It also dashed the hope of some market participants that the Fed would cut interest rates soon.
The fear among investors in the wake of the latest CPI is that inflation’s persistence could put upward pressure on borrowing costs, in turn pressuring markets. Indeed, conventional wisdom says that inflation tends to be bad news for stocks, since rising commodity prices can shrink corporate profit margins and lead to slower growth.
But what happens when inflationary pressures are persistent—and even, at times, extreme? It might surprise you to learn that in such cases, stocks have often risen, in part due to the depreciation of a currency’s purchasing power, but also because inflation can cause revenues to rise faster than costs for many companies.
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One example of this that comes to mind was the runaway bull market in commodities—particularly for energy and food—during the years prior to the 2008 credit crisis. In 2007, for instance, the price for a barrel of crude oil nearly reached 150 dollars, while gasoline prices saw sharp year-on-year price increases (in some states higher than 30%). Retail prices for certain food products (like dairy) also surged.
Yet during this period of fairly intensive commodity price inflation, stock prices also managed to levitate, with several major indexes hitting record highs. And a reason for this development is that many participants were treating stocks (particularly those with exposure to key natural resources) as inflation hedges.
A big reason why U.S. equities have lately been able to rally in the face of a high consumer price environment is likely because of current central bank policy. While some pundits and politicians argue the fed funds interest rate is “too high,” it can actually be argued that it’s too low relative to prevailing Treasury yields and other market-based indicators.
The Treasury yield curve is also rising, with the spread between long-term bonds (which are more sensitive to inflation expectations) and short-term bond yields widening. The rising yield curve implies that investors are pricing in higher inflation, but they may not be worried about any deleterious impacts on stock prices from that inflation.
More importantly, investors apparently aren’t afraid the Fed will aggressively raise interest rates in its ongoing fight against inflation…and that’s the main takeaway here. It’s also the reason why stocks aren’t likely to get tripped up by the threat of even more inflation anytime soon.
With that said, if you’re someone who is worried about inflation’s “stickiness,” what’s the best way to use stocks as a hedge against it?
The short answer is that having exposure to companies in the metals and mining, healthcare, energy and consumer staples sectors, which tend to especially benefit from endemic inflation. Confidentially, I envision these sectors will outperform in the coming months, and I think they should constitute at least a small portion of any new portfolio additions you might make in the coming months.
(As an aside, for any investors worried that the aforementioned sectors are “too hot” for consideration, keep in mind that most of these sectors are actually in a much more attractive relative position versus the “hotter”—and frothier—tech sector stocks. See chart below.)
Source: Bloomberg via First Trust
Of course, the key to using equities as an inflation hedge, as with any investment, is to know when to exit when inflation pressures become too extreme and the favorable tailwinds turn into destructive headwinds. This naturally prompts the question: how will we know when inflation’s threat to stocks becomes so great that it’s time to look for the exit?
While there’s no easy answer to this question, a simple rule of thumb is that whenever the 10-year Treasury yield index (TNX) rises to 5%, stocks are likely to experience some turbulence ahead. (Incidentally, this indicator proved to be one of the early warning signs ahead of the bear market that began later in the 2007 episode mentioned earlier.)
In conclusion, metals, healthcare, energy and consumer staples stocks should generally benefit from the ongoing inflation problem. Stocks within these sectors already beneficially constitute a portion of our portfolio in the Cabot Turnaround Letter, and I envision they’ll comprise even more new additions in the coming months.
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