As you may have noticed, markets are starting to get nervous. Having started the year strongly and finally passed the 7,000 mark back in mid-April, the FTSE 100 has bounced around the 7,000 level ever since. Similar returns have been seen in the S&P 500 and the main European stockmarkets. In theory, markets should be more confident now, and not less confident. Despite the arrival of new Covid-19 variants, existing vaccines appear to be proving effective, and economies are gradually reopening. Here in the UK, we can now go on holiday again, visit friends and relatives, and go to our local pubs and restaurants where we can now eat and drink inside.
Yet the resumption of all this economic activity has a nasty sting in the tail: inflation. Simply put, after being largely throttled back in very early 2020, expectations of surging business activity have led many observers to expect surging prices too starting with oil, plastics, metals, building materials, and commodities. As the global economy recovers, so input costs are rising steeply.
In the United States, those expectations are already being borne out. Back in early May, Warren Buffett told Berkshire Hathaway investors at their annual meeting that the American economy was running “red hot”. “We’re seeing very substantial inflation,” the Financial Times reported him as saying. “It’s very interesting. We’re raising prices. People are raising prices to us, and it’s being accepted.”
Inflation expectations have moved higher this year, with near term inflation moving higher quickly as supply constraints and surging demand will likely keep the short-run path more volatile.
For investors, inflation isn’t good news as it reduces real returns. The real inflation-adjusted returns from fixed income investments fall, pushing down prices and pushing up yields. Institutional investors respond by then increasing their purchases of fixed income investments and lowering the amount of equity investments they hold. The sell-off drives share prices down, as we’ve now been seeing, as markets remained focussed on whether the US Federal Reserve really will hold interest rates steady if growth and inflation do pick up sharply, or whether they will let it run.
And it’s also the case that returns from equity investments can fall directly, as margins are squeezed through companies being unable to raise prices in line with the cost increases that they’re experiencing.
The good news is that not all stocks are impacted by inflation to the same extent. It’s possible to sidestep some of inflation’s worst ravages in terms of the pain to your portfolio, and to your income stream, and why diversification remains an important part in portfolio construction.