Current Inflation rate and the effects of inflation on the prices of Financial assets

What is the Inflation Rate?

  • Inflation rate refers to the rate at which the general level of prices for goods and services is increasing over a specific period of time. It is typically expressed as a percentage increase in the overall price level from one year to the next.
  • There are several methods for calculating inflation, but one of the most commonly used is the Consumer Price Index (CPI) method. The CPI measures the changes in the prices of a basket of goods and services consumed by households.
  • To calculate the CPI inflation rate, the following steps are taken:
  1. Select a base year and a basket of goods and services that are representative of the typical household’s consumption patterns in that year.
  2. Calculate the total cost of the basket of goods and services in the base year.
  3. Re-calculate the cost of the same basket of goods and services in the current year, using current prices.
  4. Divide the current year’s total cost by the base year’s total cost, and multiply by 100 to obtain the CPI index value for the current year.
  5. Calculate the percentage change in the CPI index value between the current year and the previous year, and this percentage represents the inflation rate for the current year.
    For example, if the CPI for the current year is 120 and the CPI for the previous year was 110, then the inflation rate for the current year would be calculated as (120-110)/110 x 100 = 9.09%.

Interpreting if the Inflation Rate is High or Low

Generally, low inflation rates are desirable, as they indicate a stable economy and moderate price increases, while high inflation rates can lead to uncertainty, reduced purchasing power, and overall economic instability.

There is no fixed threshold that separates high and low inflation rates, as it can vary depending on different countries and regions. However, as a general rule, inflation rates of 2-3% are considered low, while rates above 5% are considered high.

It is also important to note that the perception of high or low inflation rates can depend on various factors, including historical context, expectations, and the overall economic conditions. For example, an economy with low inflation rates over a long period may view a sudden increase in inflation as high, even if the absolute value of inflation is still relatively low.

How to use the Inflation Rates when trading

Inflation can have a significant impact on risk assets, and the direction and magnitude of the impact depend on various factors, including the type of asset and the inflation rate.

What to Sell during High Inflation

In general, inflation can increase the risk associated with holding certain assets because it reduces the purchasing power of money over time. As inflation rises, the future cash flows from investments may become worth less in real terms, and the nominal returns on assets may fail to keep up with the rate of inflation.

High inflation can impact different types of risk assets in various ways, depending on the underlying asset characteristics and market conditions. However, in general, the following risk assets are likely to be affected by high inflation:

Bonds: Bonds are typically negatively impacted by high inflation because they offer fixed interest payments that may lose purchasing power as inflation increases. Investors may demand higher interest rates to compensate for the risk of inflation, leading to lower bond prices.

Growth Stocks: Stocks can be affected by high inflation in different ways, depending on the sector and the overall economic environment. Companies that rely on borrowing or that have high operating costs may suffer in a high-inflation environment, while those that benefit from rising prices or that can pass on costs to customers may perform better. Growth stocks can be particularly vulnerable during periods of high inflation, as rising prices can erode the future earnings of fast-growing companies, leading investors to re-evaluate the valuations of these stocks.

Real estate: High inflation can affect the real estate market in different ways. Property values may rise as the cost of construction and materials increases, but higher interest rates may make borrowing more expensive, leading to lower demand for real estate assets.

What to Buy during High Inflation

Commodities: some risk assets may perform well in an inflationary environment. For example, commodities such as gold, silver, and oil are often viewed as inflation hedges, as their prices tend to rise in response to increases in inflation.

Stocks: some stocks may also perform well during periods of inflation, particularly those of companies that operate in industries that benefit from higher prices, such as energy, materials, and utilities.

Energy, Material & Industrial Stocks: Companies that typically perform the best during periods of high inflation are in sectors that can pass on higher costs to consumers or benefit from rising prices. Energy companies, such as oil and gas producers, may benefit from rising commodity prices during periods of high inflation, as these companies can sell their products at higher prices. Materials companies, such as mining and metals companies, may also benefit from rising commodity prices during periods of high inflation, as these companies can sell their products at higher prices. Industrial companies, such as machinery and equipment manufacturers, may benefit from increased demand for their products and services during periods of high inflation, as consumers and businesses may seek to invest in capital goods to protect against rising prices.

What to Sell during Low Inflation

Commodities: Commodities such as oil, gas, and metals tend to suffer during low inflation as their prices are often tied to inflation expectations.

Finance/Utility/Consumer Staple Stocks: these companies are in sectors that are sensitive to interest rates and economic growth, as these companies may struggle to maintain their earnings growth rates in a low inflation environment. Financial companies, such as banks and insurance companies, may struggle during periods of low inflation as they rely on interest rates to generate income from loans and investments. Utility companies, such as electric and gas companies, may also struggle during periods of low inflation as they tend to have high levels of debt and may face regulatory pressures to limit rate increases. Consumer staples companies, such as food and beverage producers, may see slower growth during periods of low inflation as consumers may be less willing to pay higher prices for their products.

High-yield bonds: High-yield bonds, also known as junk bonds, may underperform during low inflation as investors demand higher returns to compensate for the risk of default.

Real estate investment trusts (REITs): REITs may struggle during low inflation as their profitability depends on rental income, which may not increase as much during periods of low inflation.

What to Buy during Low Inflation

Bonds: Fixed-income investments such as government bonds, municipal bonds, and corporate bonds can perform well during periods of low inflation as they provide a stable return that is not eroded by inflation.

Growth stocks: these often trade at high valuations relative to their earnings, which can make them more vulnerable to fluctuations in interest rates and inflation expectations. During periods of low inflation, investors may be less concerned about inflation eroding the future earnings of growth companies, which can support their valuations and performance.

Real estate: Property values and rental income tend to increase during low inflation, as the cost of financing and building materials remain stable.

Consumer staples: Companies that produce essential goods such as food, beverages, and household items tend to perform well during low inflation as demand for their products remains relatively stable.

Gold and other precious metals: Precious metals are often seen as a hedge against inflation, but they can also perform well during periods of low inflation as they offer a store of value that is not eroded by inflation.

Overall, the relationship between inflation and assets is complex, and investors need to consider multiple factors when assessing the impact of inflation on their portfolios. They may need to adjust their investment strategies and asset allocations to ensure they can weather the effects of inflation and achieve their long-term financial goals.