Inflation is a big problem. It is often said that this is one of the biggest unseen tax that people pay every day. In the past few years, inflation in a country like the United States has moved from less than 2% to over 8%.
The challenge among traders and investors is on how to navigate the current situation.
What is inflation and why does it matter?
Inflation refers to the price changes over time. For example, if the amount of rent you pay rises from $1,000 to $1,100, it means that your rental inflation has risen by 10%. This means that the value of your money is always going down, especially when you have no investments.
For example, the chart below shows that $1,000 in January 2000 has the same buying power as $1,712 in April 2022.
This number matters for several reasons.
First, inflation, left uncontrolled, makes people more poorer. This happens simply because wages don’t normally grow as fast as inflation over time. Indeed, recent data from the US showed that real earnings have been in the negative for a long time.
Therefore, for investors and traders, the most important goal is usually on how to beat inflation. If your investment and trading activities are able to generate returns that are above it, you will always be safe.
Affects corporate margins
At the same time, inflation matters to investors simply because it affects corporate margins. For example, a sharp increase in the price of jet fuel will always affect margins of companies in the transport industry. An increase in wheat prices will also affect the margins of firms in the hospitality industry.
What causes inflation?
In response to the pandemic, the Fed decided to lower interest rates and implement quantitative easing policies. Now, with unlimited liquidity chasing a few goods, prices had to rise.
The best example of how monetary policy affects this boom is what the Turkish Central Bank did. In 2021, even as inflation rose, the bank decided to lower interest rates. The impact is that inflation jumped to 70% in 2022.
Second, this boom is caused by fiscal actions. For example, in 2020 and 2022, the US Federal government implemented trillions of dollars in stimulus. With so much money flying around, inflation had to happen.
Other causes leading to this period are wars, geopolitical activities, political issues, and logistical challenges.
How inflation affects companies
A key challenge among investors is on how to invest in periods of high inflation. As shown below, stocks and other assets tend to underperform when this number is rising. The S&P 500 moved to a bear market when the US inflation rose to its 40-year high in 2022.
The decline happened for three main reasons. First, high inflation is usually accompanied by high-interest rates as the Federal Reserve attempts to solve the challenge.
In fact, in 2022, the Fed decided to hike interest rates by 0.50% in its May meeting. It also signaled that it will deliver many more interest rates during the year. Investors hate a high-interest rate environment.
Second, stocks decline in a period of high inflation because of the falling margins. Indeed, in 2022, while revenue growth was strong, many companies reported weak earnings.
Finally, high inflation reduces purchasing power of people. As a result, some countries experience lower margins.
How to invest in periods of high inflation
The reality is that investing in these periods is not easy. For one, in many cases, the so-called inflation hedges like Bitcoin and gold tend to underperform in such a period.
One way is to invest in or trade companies that benefit when prices rise. A good example of this is energy, which is a major contributor of inflation.
As shown below, the SPDR Energy ETF performed well during this period that happened during that year.
Short unprofitable tech stocks
Another way is to go short companies that are likely to be hurt by high inflation. A good example of these are technology companies. These companies perform poorly in periods of high inflation simply because of the Federal Reserve.
Since they are highly unprofitable, these stocks do well in a period of low inflation and low rates. As rates rise, they underperform since the Fed tends to be more hawkish in a bid to fight inflation. As shown below, the Ark Innovation Fund plummeted in a period of high-interest rates.
Further, it pays to invest in the US dollar during periods of high inflation rates. In most cases, high rates lead to more risks globally. As a result, many people tend to move to the safety of the US dollar.
As shown below, the US dollar index plummeted in a period of low value and then soared to a multi-decade high when inflation soared.
How to trade during a period of high inflation
We have looked at some of the top strategies to invest in these periods. Now, here are some of the top strategies to trade in such a period. Remember, your goal is to beat inflation and also outperform the market.
Ideally, you should embrace the same strategies that you are well aware about. By sticking to what you know, you will be at a good position to leverage your skills to beat the market. The benefit of trading in a period of high inflation is that it is usually highly volatile.
In this article, we have looked at what inflation is and what causes it. This was key to understanding how this financial instrument affects the value of an asset.
Also, we have assessed some of the best approaches to use when investing and trading during these periods. We have understood that neither approach is simple and, above all, risk-free.
For trading, for example, one of the greatest benefits is high volatility, right? But this also results in greater risks for the trader! So, we need to pay close attention and conduct our analysis methodically.
External useful resources
- Inflation Surge: Where To Put Your Money According to Experts - CNBC