How investors can profit during times of surging inflation

Easing of price pressures will lead to more demand for risk assets, equities, bonds and precious metals

History shows that when inflation is hotter than expected, markets fall. Getty

Hopes that this year’s inflationary storm might blow over were destroyed by last week’s US inflation figure, which showed consumer price growth hitting 9.1 per cent in the year to June.

Markets had expected 8.8 per cent, with some analysts predicting inflation had already blown itself out, but now the optimists are in full flight.

Clearly, there is more to come and that spells further bad news for shares, bonds, property and cryptocurrencies, although it is good news for the safe-haven US dollar.

Markets were anticipating that the US Federal Reserve would increase its funds rate by 0.75 per cent to between 2.25 per cent and 2.50 per cent in July. Now, they are betting on a full 1 per cent increase.

Ordinarily, such an increase would be unheard of, but these are not ordinary times, Joshua Mahony, senior market analyst at online trading platform IG, says.

“The Bank of Canada has already implemented a 100 basis points rate rise. The Fed could follow with an oversized hike of its own.”

Interest rates are a blunt instrument. Effectively, they operate by bashing the economy repeatedly over the head until it slumps into recession.

Higher borrowing costs hit businesses and consumers alike, and investors are already sharing their pain.

Yet, hope springs eternal and many continue to search for positives amid today’s global economic uncertainty.

And there are some positives. The core personal consumption expenditures (PCA) price index, which excludes volatile seasonal food and energy prices, is sliding, says David Morrison, senior market analyst at Trade Nation.

“It peaked at 5.3 per cent in February and has now fallen for three straight months to 4.7 per cent.”

Supply chain disruptions are easing as the global economy adjusts to the aftermath of the pandemic, Mr Morrison says.

“Markets are also pricing in the probability of the Ukraine war being a long, drawn-out war of attrition,” he says.

The oil price has dipped below $100 a barrel, after rising above $130 in early June.

Commodity prices are also on the way down, with the Bloomberg Commodity Index falling from its eight-year high of 136.61 on June 9 to about 111 at the time of writing, a drop of more than 18 per cent. Copper, aluminium, nickel, tin and other base metal prices have all fallen.

This signals that a recession is coming as demand slows, but that is unlikely to deter the Fed, which will front-load rate increases to bring inflation under control regardless of the collateral damage, Mr Morrison says.

The Fed funds rate could hit 3.5 per cent by year-end, but that could be as high as it goes and central banks could return to easing. The moment there are signs that inflation has peaked, expect risk assets to surge higher.

Once that happens, “investors will be big buyers of everything that has fallen this year: equities, bonds and precious metals”, Mr Morrison says. “We can expect a sharp fall in the US dollar, too.”

We aren’t there yet, says Richard Carter, head of fixed interest research at Quilter Cheviot.

“Central banks are clearly struggling to get a handle on inflation and more action will be required to drive it down, regardless of the economic consequences. Markets are likely to remain volatile,” he says.

Much depends on whether US President Joe Biden can persuade Middle East oil producers to increase oil supplies, Arun Leslie John, chief market analyst at Century Financial, says.

“This could prevent the world tipping into recession, although Saudi Arabia and the UAE have said they have no additional spare capacity.”

Inflation should peak but not until next spring as the base effect of this year’s big consumer price growth increases falls out of the figures, Mr Leslie John says.

The storm could last another six months, so brace yourselves.

“Futures markets now say the Fed stops hiking by Christmas and eases by this time next year,” says Ben Laidler, global markets strategist at social investment network eToro.

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Some regions will be hit worse than others, he says.

“In Europe, high energy prices are the overwhelming driver of inflation. Oil may be down but natural gas prices have doubled in a month. In the US, the major concern is the tight labour market, with unemployment near 50-year lows. The UK faces both problems.”

UK inflation is also at 9.1 per cent, and interest rates are now expected to more than double from 1.25 per cent to 3 per cent.

Inflation will have to fall dramatically and earlier than forecast to halt coming interest rate increases, says Colin Leggett, investment director at asset manager Collidr.

“Core inflation has retraced slightly in the past few months, but is still at elevated levels and well above the Fed and Bank of England’s 2 per cent inflation targets.”

Food and energy prices will continue to squeeze disposable incomes, especially if wages don’t keep up, he says.

“War in Ukraine will continue to impact energy and food prices,” says Mr Leggett.

Far from cooling or reaching a peak, inflation is on a runaway train, Jessica Amir, market strategist at Saxo Bank, says.

“It could cause an economic derailment, or recession, most likely in Europe first.”

Businesses are being squeezed by higher material costs, freight charges, higher wages, rents and higher debt repayments.

Don’t be lulled by recent falls in oil and commodity prices as they were mostly due to Covid-19 lockdowns in China, the world’s biggest oil importer and commodity consumer, she says.

“Once demand in China picks up, the lack of supply will come back into focus and prices will move higher again,” Ms Amir says, noting that Opec predicts global crude demand will exceed supply by one million barrels a day next year.

Germany is scaling up coal to rid the country of its dependency on Russian gas, which will push up prices, while major coal exporter Australia has its own energy crisis, suffering power cuts in its coldest winter since 1904.

“Demand for heating is surging but supply remains punitively low as global environmental, social and governance mandates restrict lending to coal companies,” Ms Amir says.

“The market is vulnerable to shocks over the coming months as inflation is likely to hit higher levels than expected. History tells us when CPI is hotter than expected, markets fall.”

Investors should be wary of interest-rate sensitive sectors such as technology, consumer discretionary goods and property.

By contrast, bond yields look set to climb higher as central banks increase interest rates, while gold could recover its shine.

“Since the 1970s, gold has outperformed equities through every rate rise cycle. We expect the gold price to hit a new record high later this year,” Ms Amir says.

Returns on cash will also improve, so it is worth having some exposure even though inflation will continue to erode its value in real terms.

Property is risky right now. “Values could potentially fall 20 per cent if central banks aggressively increase rates,” Ms Amir says.

We may now be heading into the eye of the storm. If Russian President Vladimir Putin retaliates against sanctions by cutting off gas supplies to Europe, things could become really turbulent.

As with all storms, this too will pass, with luck by next spring. When it does, central banks will turn dovish again. But we can expect to suffer a lot of damage first.