Investing in a time of inflation 1 Investing in a time of inflation The Bureau of Labor Statistics releases showed that inflation surged higher in April, primarily on the back of higher used car prices. We increasingly doubt the Fed’s position that this is transitory and think they will end up hiking rates far sooner than 2024. Why the doubt? At the end of this report, you should understand why. This is the highest headline month-on-month reading since September 2009 and the highest core reading since 1981. It leaves the annual rates of inflation at 4.2%. Inflation is the sustained increase in the price of goods and services. In an inflationary environment, a bag of rice that once cost $10 may jump to $15. For consumers, inflation can mean murdering a static income even further, but for investors, inflation can mean continued profit as they add to their portfolio. To contextualize the lingering talk about the unusual inflation, the chart below reveals the relationship between inflation in 2019, 2020 and the unusual galop in April 2021. "The argument is whether this period of inflation is transitory or here to stay. And time will tell. I think it's here to stay until you see labour costs and commodity costs mitigate some," said Peter Tuz, president of Chase Investment Counsel in Charlottesville, Virginia. But then, who can be so sure? To some analysts, the biggest inflation scare in 40 years has arrived, sending stock-market investors back to the history books for a look at what does and doesn’t work when prices are rising. Let’s take a look at the impact of inflation versus the general stock market performance Fig 1 : Source : U S Bureau of Labour Statistics ( BLS ) Some of the findings are intuitive: Stocks of companies more closely tied to the economic cycle and that are best suited to passing on price increases, preserving their margins, can thrive during periods of rising inflation While there are opportunities to pick up some growth-related stocks that appeared oversold during the first-quarter rotation, improving data on the economy and vaccinations should continue to benefit cyclical. Source: US Bureau of Labour Statistics (BLS), Yahoo Finance S&P 500 Return Avg. Inflation 0.4 0.2 0.0 -0.2 1960 1970 1980 1990 Year 2000 2010 2020 Avg. Inflation -0.4 S&P 500 Return and Avg. Inflation by Year (1960 - 2020) Inflation Vs General Market Return Judging from the performance of the S&P 500 over the past 60 years, there is no obvious correlation between the U.S. inflation and total market returns. According to N ick D eacon, H ead of Real E state Investment at N uveen, “ as long as the F ed doesn ’ t appear to be walking back its promise to hold off on tightening, rising rates will likely remain relatively low ” C ompanies more sensitive to interest rates, which get pushed up as inflation e x pectations periods, are seen a s more likely to suffer, at least relative to their more cyclical counterparts. Brian Belski, chief investment strategist at B MO C apital M arkets, took a detailed look at the sectors and industrie s that have historically performed best — and worst — during periods when inflation was behaving much lik e it is now. 2 Investing in a time of inflation 0.60 Relative Performacne for Energy and Industrials Were the Most Positively Correleted to the PPI-CPI Differential Across S&P 500 Sectors Correlation Between Sector Relative Y/Y Price %Chg and Y/Y %Chg in US PPI Final Demand Goods Minus Y/Y %Chg in US Headline CPI monthly S&P 500 data since 1990; COMSV Starts in 2007 and uses consists as of Sept 18 for historical data, REAL USES S&P US REI Communication Services Consumer Discretionary Consumer Stables Energy Financials Health Care Industrials Information Technology Materials Real Estate Utilities S&P 500 0.40 0.20 0.00 -0.20 -0.40 -0.28 -0.21 -0.22 -0.11 -0.24 0.34 0.03 0.03 0.22 0.12 0.18 Source: BMO Investment strategy Group, Factset. Haver, BLS. As the chart shows from a broader perspective, the S&P 500 overall has a positive correlation of 0.18. Among the index’s 12 sectors, energy (0.49) and industrials (0.34) are the most positively correlated, while communication services (-0.28), healthcare (-0.24), and consumer discretionary (-0.21) are the most negatively correlated. *Correlation measures the strength of a relationship between two variables. A positive correlation of 1.0 would mean they move the same direction in lockstep, while a correlation of -1.0 would mean they move equally in opposite directions. A correlation of 0 means there is no statistical relationship. Belski and company further broke the analysis down to the industry level, as shown in the chart below: 0.80 0.60 0.40 0.20 0.00 -0.20 -0.40 -0.60 Construction Materials specialty Retail Pharmaceuticals Multiline Retail Household Products Food Products Beverages Building Products Software Food & Stamps Retailing Multi utilities Electronic e q uip, Instr & comp Consumer Finance Machinery Metals & Mining Road & Rail Electrical E q uipment Energy E q uipment & Services Oil, gas Consumable Fuels Construction & Engineering Of the 10 S&P 599 Industries Most N egatively correlated to the PPI-CP Differential, Fou r Came From the Consumer Staples Sector Top 10/Bottom 10 S&P 500 Insustries By correlation Between Relative y/y Price % chg and Y/Y %Chg in US PPI Final Demand Goods Minus Y/Y %Chg in US Headline CPI Monthly data since 1990 or at least 20Y of history Source: BMO Investment Strategy Group, Factset, Haver, BLS. 3 Investing in a time of inflation 4 Investing in a time of inflation What does this mean? Belski isn’t convinced that the recent surge in inflation — marked by an April consumer-price index year-over-year jump of 4.2% — will translate into a prolonged period of elevated inflation. Contrary to market fear, and some high-profile investors and academics, he also doesn’t see the Fed risking a policy mistake by refusing to pull forward its timeline on tapering asset purchases and delivering rate hikes. Now, investors are turning their attention to upcoming economic reports that could fill in the inflation picture, especially U.S. producer prices data and job reports. With the economy roaring back, jobs returning and inflation likely to remain higher for longer, we continue to see the risks skewed towards an earlier interest rate rise in the first quarter of 2023 than the Federal Reserve current projection of early 2024. In such a scenario, we could see gross inflationary impact in the stock market after the Federal Reserve raises the interest rate. For now, there are zero calls for alarm. Overall, stocks are a “real asset,” which means that all else being equal, they should rise as inflation picks up. But performance ultimately may depend on the broader economic context around rising prices. Stocks have a reasonable chance of keeping pace with inflation - but you should also remember that - not all equities are created equal. For example, high-dividend-paying stocks tend to get hammered - like fixed-rate bonds - in inflationary times Investors should focus on companies that can pass their rising product costs to customers, such as those in the consumer staples sector. All of the views expressed in this report accurately articulate the writer ' s independent views / opinions, based on public information regarding the companies, securities, industries or markets discussed in this report. T he writer ' s compensation or remuneration is in no way connected ( either directly or indirectly ) to the specifi c recommendations, estimates or opinions expressed in this report. I m p o r tant D is cl os ur es