It seems that rate hikes are inevitable in the face of rising inflation. Indeed, as the Federal Reserve announced in December that it would hike rates at least three times in the course of 2022, its European counterpart announced that it would be ready to announce rate hikes in 2023.
At around the same time, the Bank of England surprised markets by hiking rates immediately.
How bad is inflation?
The Fed uses the Consumer Price Index (CPI) to measure inflation but as the number is only an indicator of the increase in prices based on a basket of different items, it doesn’t capture fully the overall impact on common citizens. For instance, in November, the CPI climbed by 6.8% in the year through to November. By stripping out of food and fuel, this number stood at 4.9%.
In terms of the year-to-date increase, this was declared the fastest increase in inflation since 1982 for the total basket and the fastest reading for the modified basket that removed food and fuel since 1991.
However, in practice, the US Labour Department’s inflation numbers were much grimmer.On the 12th of January, the data announced for the calendar year of 2020 showed that food prices had jumped 6.3% while used car prices rose 37.3%.
In short, the rate of increase in prices is far worse and not directly implied by the CPI. Nonetheless, the CPI is used to inform investors on the direction that the “Fed” might take to address the situation.
The real question for investors amid these conditions is where to take refuge.
Markets and Treasury bonds
As the Fed rate influences the prime lending rate, any hike would mean everything from credit cards to car loans will be affected. From a market perspective, there will likely be an expectation of long-term loans’ yields rising, which the market tends to price into long-term Treasury notes.
The reason why the expectation comes to coincide with the increased yield in the long run is that there is also an expectation that the Fed would then start supplying more short-term Treasuries which collects money and tightens the money supply. Thus, the lowered rate of inflation would dampen the effectiveness of the higher yield.
Through most of the 1970s through the earlier part of the nineties, US Treasury bonds – particularly the 10-year bonds (TNX) – were a viable investment destination for US investors.
Since the nineties, as US government debt began to increase, yields began to fall while the market, represented by the S&P 500, began its now-meteoric rise.
What about gold?
The idea that gold represents wealth has been built into social psychology since the dawn of civilization. Less than 10% of gold is mined for industrial purposes with the rest relegated to being either jewellery or bullion.
Gold prices began to rise particularly after the financial crisis when investors flocked towards its relative safety. This, of course, came to a screeching halt shortly around the time the Fed announced it was about to halt its stimulus program. The price of gold continued to fall through 2012 to 2015, picking up again after 2015 as government debt continued to grow.
If inflation containment measures find little traction, it can be expected that the price of gold will begin to rise, benefiting both holders and gold mining stocks.
There is no alternative to markets – with a caveat
US Treasury yields are very far away from becoming an effective alternative to the market for investors. For instance, in 2021, the S&P 500 gained 26.9% in 2021 while the Nasdaq Composite gained 21.4%.
However, the breadth of this rally is expected to narrow as consumption falters due to rising costs. In December 2021, Goldman Sachs strategists revealed that just five stocks – Apple, Microsoft, Alphabet, NVIDIA and Tesla – accounted for 51% of the S&P 500’s returns seen since April.
These five accounted for around 33% of the year’s returns and about 20% of the total market capitalization with respect to the index.
The reason for this is that the speculation and outlook that drives the rise in tech/growth stocks – i.e. technical innovation, future business models etc – tend to lose value as investors seek refuge in stocks that represent companies in classical business areas.
In Conclusion
There are a number of strategies for investors, depending on the time horizon they’re most comfortable with.
If the time horizon is beyond that of the time taken for inflation normalization, growth stocks – such as leading tech names – will tend to shrink from their inflated ratios down towards more reasonable levels. This presents an opportunity which is both risky but potentially rewarding in, say, five to 10 years.
While gold might preserve value it likely won’t deliver inflation-busting gains but for the equity investor, holding top stocks with classical business models such as oil and financials, i.e. diversifying from tech stocks, will likely safeguard portfolio value as tech ratios normalize.
Sandeep Rao is a researcher at Leverage Shares. The views expressed above are his own and should not be taken as investment advice.