Cici's Teaching Notes📝: What is the inflation resistance of different assets?

A downturn in the economy and recession expectations combined with high inflation is one of the biggest headaches, and in the Merrill Lynch clock, it is called Stagflation.

GDP growth slows, but inflation is still high. Productivity is falling, and a wage-price spiral is developing as companies raise prices to protect compressing margins. This continues until a sharp increase in unemployment breaks the cycle. Central banks maintain high rates until they rule inflation, causing the yield curve to invert. At this stage, cash is the best asset. As shown below.

In today's note, we explain in detail with you how inflation affects the performance of different assets, so that you can better grasp the cycle of the economic cycle once you understand it.🤔

To understand the impact of inflation on various assets, we must first understand the pricing logic of various assets.

Let’s looking at bonds first, the interest rate on a bond is determined in advance and is not affected by inflation during the period it is held after it is determined.

However, when higher inflation is expected in the future, the new bond issue needs to have a higher interest rate so that people will want to buy it.

Then the newly issued bonds are more attractive compared to the already issued bonds and money is more willing to buy the newly issued bonds, which will drive down the price of the already issued bonds.

For stocks, when expected future inflation continues to rise and exceeds expectations, corporate profitability becomes more uncertain and the risk premium the market demands on equity assets rises and the P/E ratio falls, so rising inflation usually leads to lower stock prices.

And when the level of inflation is low and mainly demand-driven, this is when upward inflation often means increased corporate profitability. The increase in corporate profitability brings about an increase in the value of equity assets, which drives up share prices.🥳

In addition to the common bonds and stocks, there are many alternative assets that can be effective against inflation.

For example, real estate. In particular, home prices in first-tier cities have risen well above the rate of inflation. There are also many studies that show that holding real estate directly can provide a good hedge against inflation in the long run. Because rental yields are a key part of real estate returns, rents can be adjusted for inflation. When inflation is high, rents tend to rise accordingly.

Then there are commodities such as crude oil. Because rising energy prices are in many cases the primary cause of inflation, many commodities are reasonable inflation hedges.

Also gold, as a safe-haven asset against financial turmoil, tends to perform better during periods of strong market risk aversion and sharp increases in inflation. So we've also seen gold generally perform better so far this year especially when inflation continues to be high.

This post does not incorporate interest rate hikes, but mainly hopes to explain the impact of inflation itself on other assets.

What other investment categories do you know that do better under the influence of inflation? Feel free to share in the comments.