Inflation and shares

Inflation and shares

We have been bombarded with talk about the high level of inflation throughout the world with some countries experiencing inflation as high as 20%. There’s been lots of speculation about how high inflation is likely to go and what governments can do to reduce inflation to more ‘reasonable’ levels. So let’s take a closer look at inflation and especially the impact of high inflation on company profits and share prices.

What’s inflation?

Inflation is the increase in prices of goods and services. As time goes on, consumers have to pay more for anything they spend money on – including interest on loans, the cost of services they need or the price of goods they purchase.

Why do we have inflation?

The causes of inflation aren’t well defined or easily explained. Basic economic theory says the price of any commodity is determined by the balance between supply and demand. For example housing prices in Australia have been steadily rising because there has been a consistent surplus of demand over supply. Put simply – there are not enough houses on the market to satisfy the demand for housing (particularly in ‘desirable locations’) so house prices keep rising.

Because prices depend on the balance point, it doesn’t take much of an imbalance to cause prices to move. It’s generally thought that reasonable inflation is better than the opposite – deflation, so that’s the way it’s been for many years.

How is inflation measured?

Inflation in Australia is measured by the consumer price index or CPI. This is an index of the relative movement in price of a basket or goods and services required by the ‘average’ consumer. The mix in this basket changes as time goes on and consumer demand changes with the times.

What’s a reasonable level of inflation?

In Australia the RBA aims to keep the CPI between 2 – 3% as this is considered a reasonable and stable level of inflation.

Why is inflation currently so high?

There are several reasons for this.

• The COVID global pandemic which caused huge disruption to the demand for and supply of goods and services so much so that many smaller businesses were forced into closure. Now the pandemic is easing, the increase in demand has not been matched by increasing supply.
• The war in Ukraine which has disrupted the supply of essential goods and services, pushing prices up.
• A shortage of labour. In Australia as businesses have been trying to expand to meet the increased demand they are often unable to obtain the employees they need. This in turn reduces output and increases the ratio of demand over supply.
• Global warming. This has caused unusual weather patterns resulting in droughts or floods which in turn disrupt the steady growth of the economy in all sorts of ways.
• Change to a greener economy. Many nations are trying to reduce their greenhouse emissions and move to renewables. In the long run renewables may end up being a cheaper alternative but in the transition period energy supply costs have risen and added to inflation.

What is the Government doing about inflation?

Traditional economic wisdom is for a government to reduce inflation by increasing interest rates and this is the approach almost all governments are taking. Increased interest rates result in a lower disposable income for consumers – almost all of whom have a large amount of loan capital (particularly in the form of home loans and credit cards). This clamps down demand and tends to restore the balance between supply and demand.

What effect does inflation have on shares?

As a share investor I’m most interested in the effect of inflation and increasing interest rates on shares. Generally speaking inflation and rising interest rates aren’t good for shares. There are a number of reasons for this:

• Rising interest rates dampen demand, so consumers spend less and the reduction in sales hurts company profits whether they are producers or retailers.
• Almost all companies have a sizeable proportion of their capital as loan capital. As interest rates rise they (like everyone else) have to pay more interest on their loans and this reduces profitability.
• Rising inflation means companies have to pay more for the goods and services they need and this in turn reduces profits because they generally can’t recoup all their rising costs by increasing their prices. The exception to this are the banks because they usually quickly pass on the interest rate rises to their loan customers and so recoup the cost increase.
• In Australia, as our economy began to recover from the worst of the Covid epidemic, there was an increase in unemployment and a labour shortage. To counter this most companies had to increase wages to try and fulfil their labour requirements and this in turn increased costs. In many cases the required labour couldn’t be found so output decreased and this reduced revenue.

As a share investor what should you do?

With the wisdom of hindsight you would most likely come to the conclusion that you should sell your shares as the economy (and share prices) downturn, then buy back as the economy recovers. On paper, this is the best strategy but in practice things aren’t so straightforward. No one can see into the future so it’s very difficult to get the timing right in real time and to sell and re-buy at the best times. Share prices don’t usually move in a consistent, predictable patterns but often experience sudden rises and falls.

 Furthermore if you sell a big batch of shares at one time you’ll most likely have a large capital gain which in turn could trigger a big tax liability in that year. And of course, there will be a big brokerage charge which doubles when you buy back again. Finally there’s a lot of paperwork and effort involved when you sell shares and then buy them back.

If you’re an active share trader (rather than an investor), the sell-rebuy strategy may appeal but for a longer term share investor it’s usually better to simply ride out the storm. Hang on to the quality shares you have, knowing they are sound companies and that their share price will eventually recover. If shares pay a reasonable dividend, the steady dividend can help a lot to combat inflation. For example most of my quality core shares currently have a yield of around 6%, and are fully-franked so this equates to a grossed-up yield of around 8.5%, which is enough to outstrip inflation.

If you have a proportion of ‘species’ in your portfolio it may be wise to sell them early in the piece as these types of shares usually don’t fare well in a downturn, and may not recover as the economy recovers. This could provide you with funds that enable you to increase your holding in quality shares while their prices are depressed.

In other words, don’t worry and be happy while you wait for things to improve, secure in the knowledge that they eventually will. The economic clock tells us that economic cycles are the norm and not the exception. What goes down will in time come back up (usually to reach new highs).