almost 3 years ago • 3 mins
As the US and Europe steadily cast off coronavirus-induced restrictions on movement and business, the prospect of inflation in earnest is back on the agenda. So I thought it’d be a good time to take a look at which parts of the stock market are likely to do best if price rises really do pick up.
After a pandemic-fueled plunge early last year, expectations for future inflation have rapidly rebounded. The chart below shows the average percentage rate of US inflation anticipated over the next 10 years as implied by bond prices – a.k.a. the breakeven rate.
As you can see, investors are now expecting the fastest medium-term US inflation for several years. The country’s consumer prices index has averaged 2% over the past two decades, so a rate of 2.2% would hardly be unprecedented. But all the combined central bank and government stimulus currently flowing into the all-important US economy could see inflation rise even higher – with potentially serious ramifications for your investment portfolio wherever you are.
Inflation is clearly toxic to bond prices, since it reduces the value of their fixed coupon payments – so don’t expect any shelter there. Its impact on the stock market is more nuanced, however: certain industries may be hit hard while others do just fine. Fund manager Invesco recently examined how different sorts of stocks have historically behaved during periods of rising bond yields (and by extension rising inflation expectations).
The chart below plots the average return of each sector relative to the overall market against that sector’s “hit rate” – or how consistently it’s behaved that way. Industrial goods and services, chemical, and energy stocks beat the market most consistently when bond yields are rising: perhaps unsurprisingly, given their reliance on strong economic growth, which often goes hand in hand with higher inflation.
As always, you can find plenty of easy-access exchange-traded funds (ETFs) tracking these sectors, like the Vanguard Energy ETF or the Industrial Select Sector SPDR Fund. But if these plain vanilla sector-focused ETFs don’t appeal, then you may want to have a look at an actively managed fund aiming to mitigate the effects of inflation.
Investment manager Horizon Kinetics, for example, launched its Inflation Beneficiaries ETF in January with the memorable ticker INFL. The firm’s professionals have selected an interesting list of stocks for the fund, including food processor Archer-Daniels-Midland and large oil-producing-landowners Texas Pacific Land Trust and PrairieSky Royalty.
Horizon’s also betting that any inflation-fueled increase in commodity prices will flow through into higher earnings at data and trading hubs like Intercontinental Exchange and Germany’s Deutsche Börse. Of course, you could cut out the middleman and invest in some of these companies directly…
In closing, I think it’s worth pointing out that sustained inflation is far from guaranteed. Plenty of people have been calling for prices to take off ever since central banks started buying bonds in response to the 2008 financial crisis – only for their predictions to be proved wrong time and again.
What’s more, as markets adjust in anticipation of events, many of the stocks and sectors mentioned in this Insight have already seen significant gains. It may well take inflation rising even more than currently expected for them to climb further. So keep an eye on that breakeven rate.
Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.