The Positive Correlation Between Equities and Inflation
Why equities can offer protection against inflation ?
Inflation is a key concern for investors as it can have a major impact on the value of their investments, meaning it is vital to diversify and explore measures to protect invested wealth. When prices are rising, the purchasing power of money decreases, which can lead to a loss in the real value of investments. In these scenarios equities provide a nice hedge against inflation and reap better returns compared to, say, fixed-interest bonds. Below we breakdown what this opportunity means for investors.
What is inflation?
Inflation is the rate of increase in prices or cost of living over a given period of time, usually a year, and represents how much more expensive the relevant set of goods and services has become. It essentially depreciates the currency's purchasing power as an individual can now buy fewer things with the same amount of money as before. As a result, the cost-of-living increases. In addition, the central bank raises the interest rate on borrowings to curb inflation. This makes borrowing expensive for companies which has a negative effect on the earnings and stock value of certain sectors, reducing investors’ overall financial gains.
What are equities?
The term ‘equities’ is used alongside ‘stocks’ and ‘shares’ to describe units of ownership of a company. An individual who owns equities, shares or stock is generally referred to as a ‘shareholder’. Investing in equity allows individuals to become shareholders in public or private companies, granting them the right to a share of future profits, company growth, and the ability to participate in decision-making through shareholder votes. Broadly speaking, history indicates that owning shares has outstripped the returns available from cash over the long term and has been one of the few asset classes providing a real return after the effects of inflation are taken into account.
What is the relationship between equity and inflation?
Equities, being tangible assets, can be a reliable safeguard against potential inflation surprises because a rise in prices should correspond to a rise in nominal revenues and boost share prices. The impact of inflation on earnings will vary by the economic sector and its ability to pass on higher input costs to consumers, but if input costs don’t increase at the same rate as revenues the rise in profit margins should translate into greater nominal earnings.
Moderate inflation is generally good for equities because it tends to be associated with positive economic growth, rising profits and stock price gains. Research indicates that equities have historically delivered inflation-adjusted returns at these low to moderate levels of inflation, outperforming bonds.
In a nutshell, it is advisable for investors to take the necessary steps to diversify their portfolios and explore equities, ensuring they preserve the value of their money in the face of inflationary pressure.
That said, inflation rates and their impact can be volatile and unpredictable, so seeking advice from a financial professional is always advised for those looking to preserve their finances and plan for their individual goals. Investors can and should seek the guidance of experts to ensure they pursue the relevant sectors where growth prospects are not endangered by inflation.