According to former US president Ronald Reagan, “Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man”
In an economic sense the definition of inflation is – “A general increase in prices and a fall in the purchasing value of money”.
Inflation is an integral part of the capitalist system, put simply, as an economy begins to thrive, demand for products will rise as more people are employed and they have more to spend. As demand rises the cost of materials and production rises and these increased costs will be passed on to the consumer, pushing up the prices we pay.
Sometimes prices will rise because of increasing demand, sometimes because of a shortage in the supply of materials or labour and sometimes because of an external event (like during the Covid 19 pandemic where most of the world shut down, reducing production but demand increased as we all shopped more while we got paid to stay at home).
As prices continue to rise, eventually the consumer reduces or stops spending, so businesses, both wholesale and retail will see a fall in sales and begin to cut their costs. Labour, or employees are generally the most expensive element of a business’s overheads and so they tend to be reduced first when business income goes down. This might be in the form of reduced hours for staff or worst-case scenario, redundancies.
With less people in work, spending in general reduces and eventually prices will stabilise or come down.
For these reasons, Inflation has the power to plunge an economy into recession, so naturally, governments all over the world try to control it tightly and maintain a comfortable rate of annual price increases, a sort of natural inflation that is balanced enough to give companies rising profits so they can grow and maintain employment and profits while we the consumer have rising incomes that enable us to keep spending – which helps to maintain the growing economy.
In the UK, the annual target rate of inflation set by the Bank of England has been 2% for a number of years, today (3rd May 2022) the Bank publishes the current rate of inflation as 7%.
As a result of the Covid pandemic, conflict in the Ukraine and a thriving economies inflation has risen today to levels not seen since 1991 when the rate of inflation on an annual basis was 7.5%
Why does this matter to the stock market?
Generally, inflation and rising interest rates are both bad for the stock market.
As outlined above, controlling inflation is good for the economy as a whole and we have managed to do that for many years now. But once inflation gets out of control and rises above the Bank of England’s target, the only way to bring it back down again is to increase interest rates.
Rising interest rates stifle company borrowing and expansion, make our mortgages and credit more expensive and attempt to slow down the economy, hopefully slowly, to avoid pushing it in to a recession. This is known as a “soft landing”.
So, when inflation rises, companies know that interest rates will be rising, and sales may slow down so company profits may fall.
Investors know this too and consequently, in fear of falling company profits, may start to sell shares in those companies that they feel are most likely to be affected. (Recently, we have seen this with falling Technology share prices, especially in those companies selling subscription based services, after Netflix, which saw subscriber numbers falling massively and a subsequent 23% drop in its share price. Netflix has other problems and inflation is likely not the main cause of its recent demise but investors aware of rising inflation are fearful of consumers cutting subscriptions to services like this as the general cost of living rises.)
Typically, it can take 9 months or more before the economy will start to see the effect of a central bank’s actions in raising interest rates. So, we can anticipate it may take around 9 months to slow and stop rising inflation and around 9 months more to see the economy start to rise again as we get inflation under control.
The challenge for the central banks is engineering the soft landing, because if they don’t, we could be pushed into a full-blown recession or worse, like 1929, a depression.
Where are we now?
During the pandemic we saw a massive increase in spending in some areas as we stayed at home and shopped. Before then, world economies were showing some signs of weakness, but we saw an artificially stimulated rise in economic growth after the initial massive falls in GDP (Gross Domestic Product – the income of a country overall) at the start of the pandemic lockdowns in March 2020.
This sudden rise in spending, compounded by supply problems after the lockdowns kick started the aggressive rise of inflation. The debate initially was, is the new inflation transitory? (i.e. is it here just for a short while because of Covid 19).
Because a lot of economic news is still quite good – unemployment figures remain low for example – and we are likely now carrying on the natural cycle interrupted in March 2020 by the pandemic, current opinion has settled on current inflation not being transitory, it’s here to stay for the natural cycle.
Recently, the debate has changed to be more forward looking – are we now seeing peak inflation? We look for the end of rising inflation as a sign we have completed the first 9 month phase of the cycle (see above).
Examples of this that encourage commentators to believe this are; in the US, Bond markets are potentially peaking around 3%, property sales are slowing and used car sales are peaking. Not always, but often, the UK follows the US in economic activity and we are starting to see signs of these things here too.
If we are approaching peak inflation, we could move into the next phase of consolidation and controlling inflation again which could be good for the stock markets, given the overall reasonable economic picture in many countries. This could lead to a good second half for equities in 2022 with good quality companies rising again into the year end.
Focus has now switched to those companies that have good strong earnings, strong cashflows and make or provide something the consumer needs and wants. A bit like in the Technology bubble of the late 1990’s, no-one wants to invest in companies that have great potential but don’t make any money yet!
How can we assist?
Inflation really does live up to its description in the Ronald Reagan quote, it affects our lives by dominating the cost of living, but is vital to the overall economic jigsaw of long-term prosperity. However, although it is a vital component, it is equally vital that it is kept under control. But in trying to keep it under control we can easily make the situation better, or worse!!
As an overall barometer, high inflation is bad for the stock market and low or stable on target inflation can be good for the stock market, so it can be a useful factor when deciding how to position your portfolio going forward.
If you would like more information about reviewing your investments or to discuss starting investing, get in touch at firstname.lastname@example.org or contact us here: www.middletonprivatecapital.co.uk/contact-mpc/