Earning Money Through Inflation, Market Fluctuations, and Instability
The U.S. Federal Reserve's pandemic stimulus, characterised by aggressive asset purchases and near-zero interest rates, has contributed to a significant increase in inflation, reaching the highest levels in 40 years during the post-pandemic reopening. This was partly due to the stimulus increasing the money supply and supporting demand while supply chains were still disrupted.
In response, the Fed has raised interest rates sharply to combat inflation, shifting monetary policy into a restrictive stance. However, recent signals suggest potential rate cuts later in 2025, with markets pricing in several cuts amid weaker labor markets and political pressure.
For investors, these developments have several implications:
- Interest Rates: The Fed’s initial rate hikes have created a restrictive monetary policy. However, potential rate cuts in the future could reduce borrowing costs. Yet, these cuts might raise concerns about the Fed’s commitment to inflation control if inflation remains elevated.
- Equity Valuations: Rising inflation and uncertainty about the Fed’s policy direction tend to pressure stock prices. Potential rate cuts amid persistent inflation might weigh on markets, as investors question the stability of returns and may shift allocations away from U.S. equities.
- Foreign Currencies: Expectations of a looser U.S. monetary policy (rate cuts) could weaken the dollar. This environment favors greater allocations to international assets denominated in foreign currencies to diversify and hedge risk.
The consumer's role has evolved as well. Pandemic stimulus left consumers initially flush with cash, fueling spending and inflation. Today, consumers feel financially stretched, and demand is more elastic, which may put downward pressure on prices and dampen inflation in the medium term.
Certain sectors of the economy are more sensitive to inflation than others, with precious metals, consumer staples, utilities, real estate, materials, and financials being the best sectors as inflation hedges. Inflationary environments tend to favour low P/E stocks, making value equities more attractive.
The war in Ukraine has created significant risks and uncertainties for investors. Certain materials and natural resources are undersupplied, with the Russia conflict further constraining supply, making this area of investing a potential long-term allocation. Commodities and commodity-producing countries are under-owned as investments, representing an opportunity for smart investors.
Allocating to countries that will benefit from increased resource demand can benefit both the earnings power of companies and the appreciation of the country's currency. Creating an equity allocation strategy that includes growth and value can provide portfolio balance, with a tilt towards value equities and blue-chip growth companies in this environment. Real estate sectors that have frequent payment resets can act as a good inflation hedge.
The Fed increased rates by 25 bps on March 16th and is guiding markets to expect 6 more increases this year, but the forecast is up for debate due to the Russia/Ukraine conflict. Oil and gas are inelastic commodities, meaning that supply does not change much when prices increase. The global supply of oil was already tight due to lack of investment in exploration and production, environmental concerns, and net zero government policies.
History suggests that it is best to invest when fear is high. Debtor strategies and short duration assets are beneficial when rates are rising. Long volatility strategies benefit from higher market volatility.
In summary, the Fed’s pandemic stimulus triggered strong inflation, prompting aggressive rate hikes. Investors should prepare for possible easing later in 2025, impact on equity valuations from policy uncertainty, and consider international diversification due to expected dollar weakness. The environment remains complex due to ongoing inflation risks, supply chain adjustments, and changing consumer behavior.
Investors might need to reassess their strategies due to the potential future rate cuts mentioned by markets, as these cuts could reduce borrowing costs but potentially raise concerns about the Fed's commitment to controlling inflation. Additionally, for those interested in investing, certain sectors such as financials can serve as inflation hedges, making them attractive during periods of high inflation.
