Inflation is defined as the general increase of prices for goods and services. Governments may try and control inflation by increasing interest rates. Share markets do not like increases in interest rates as it can increase company loan repayments and hurt earnings. It can also discourage businesses from borrowing more money to expand. However, there are some sectors that perform well in high inflationary environments.
If inflation becomes high, an increase of interest rates will follow. Banks make most of their money from interest revenue they receive from their borrowers. Hence if interest rates increase, then banks’ net interest margin increases. This is the difference from the interest income they receive and the interest income they need to pay out.
There is a positive correlation between the price of oil and inflation. The consumer price index helps measure the inflation in the economy by tracking a basket of goods and services by households. Energy costs in households would be included in the consumer price index. As the oil prices increases, this directly affects the energy costs spent by consumers. This would lead to an increase in the CPI index and then inflation. Oil stocks should do well in high inflation environments.
In a high inflationary environment, consumers will cut down on consumer discretionary goods as the cost of basic goods and services will increase. Household budgets will become stretched so consumers will be less likely to spend their money freely in when inflation is high. However, consumer staples will still be high in demand as the higher prices will not deter the customer from buying things that are essential.
Healthcare is another sector where demand will be unchanged even if there is higher inflation. This is an essential service so consumers need healthcare regardless of what is happening in the economy. In inflationary environments, investors tend to sell out of high-risk stocks and rotate into defensive sectors such a healthcare and consumer staples. These sectors are seen as safer and there is more reliability with their revenue streams compared to other sectors.
Similarly to consumer staples and healthcare, consumers will continue to use utility services when household budgets are tight as they are essential services. If operating costs increase for these energy companies, they will pass these higher costs to consumers and keep their profit margin. Consumers will need to use their utilities so they cut back on spending elsewhere.
Lauren Hua is a private client adviser at Fairmont Equities.
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