Inflation – yes or no?
So what exactly caused the market volatility we saw over the past couple of weeks?
Well after 14 months of the news being dominated by Trump and covid-19 we finally have something else to worry about - Inflation.
What does inflation mean for stocks?
Higher inflation is usually looked on as a negative for stocks because it increases borrowing costs, increases input costs (materials, labor), and reduces standards of living. But probably most importantly in this market, it reduces expectations of earnings growth, putting downward pressure on stock prices.
The stock market does expect a certain amount of inflation, but if suddenly that expected amount increases it can spook investors as we have recently seen.
However not all sectors of the market will react in the same way – hence always owning a well-diversified portfolio. For example, growth stocks tend to under perform when inflation is higher. That’s because growth stocks have much of their earnings expectations in the future (i.e., their earnings tend to increase rapidly year after year), and when rates rise, it reduces the value of those future higher earnings. Value stocks tend to be hurt less (their earnings tend to be much “flatter” over future years).
Is inflation ever good for stocks?
Inflation however, is not all bad, with mild or moderate inflation generally seen to be good because it’s a sign the economy is growing, and businesses can raise prices. The “sweet spot” for inflation is generally seen to be between 2% and 3%, exactly where it currently sits. At this level the highest stock market returns have historically been seen, as stocks will provide protection against inflation, as a company’s revenues and profits should grow at the same rate (or greater than) inflation
So why the volatility?
Inflation only becomes an issue when it moves up so much that interest rates are raised to try to slow it down. For the last 14 months we have seen nothing, then a couple of weeks ago the stock market started to attempt to price in the chance the Federal Reserve will have to raise rates sooner than many anticipated.
So what should you do as investors?
Stick with your long term investment plan and makes sure your diversified portfolio is made up of both growth and values stocks in both Canada and the U.S.
Vice-President and Portfolio Manager
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