Periods of strong inflationary pressures have ample potential to significantly affect global financial markets.
Given the nature of this material related to inflation and its impacts on financial markets, it is extremely important that we start with a simple and straightforward definition of what inflation represents.
Inflation is a term which has been assigned to an economic event where the price increases of a basket of goods and products are measured in a given time. In an even simpler way, inflation is neither more nor less than an economic metric which tells us how much the prices of the main items in an economy have advanced.
This economic data is of extreme importance, since price increases are a good indicator of economic activity, while when they explode, a clear indicator of how much the pockets of citizens in said country or region could be affected.
The metric as such is usually presented in two formats, the main and the underlying, where the first considers practically all the most important goods in a basic basket, while the underlying discards those components that tend to be more volatile (Food and Energy ). Additionally, this is presented either monthly (price increases from one month to another) and annually, where here the prices of a month are compared with the value that was registered during that same month the previous year.
As a final point before we enter the impacts of inflation on the markets, we must remember that this metric is extremely important in the range of economic data, since the vast majority of central banks globally, together with unemployment, have the objective of maintaining inflationary levels at an adequate level. Said level represents one in which inflation is not too high to create financial instability, although it is not non-existent either, with the purpose of encouraging economic activity.
With this in mind, we now proceed to observe how inflation affects each different branch of assets in the global financial arena.
In Forex, the first thing we have to consider is that this is a market in which currencies from different countries trade in relation to the currencies of other countries. Easily put in the foreign exchange market, a currency trades against another currency, therefore, here we will have to consider how the inflationary phenomenon is developing in one country against another.
The basic premise here is that strong inflationary levels in a country are very likely to cause the central bank of that economy to proceed to increase the target interest rates, in order to mitigate the continuous unbridled advance of prices, and thus return more That currency is attractive.
Now, not everything is so simple, since certain countries may be confronted by other phenomena which limit how much the central bank can restrict its monetary policy (Geopolitical, economic, humanitarian).
One of the best examples we have at the moment is the situation in the EUR/USD. On the one hand, here we have the Fed, where given the high levels of inflation in more than four decades, it has been willing to considerably increase the levels of target interest rates. On the other hand, although the Eurozone is also registering high inflationary levels, here the European Central Bank has the complications that the conflict in Ukraine could have a greater unfavorable economic impact and therefore they have decided not to be so aggressive in their policy. to increase rates at the moment.
This divergence has caused the dollar to strengthen strongly against the euro and has given great trading opportunities to those traders who operate with the trend. To the contrary, this market condition has been one in which reversal traders have suffered quite a bit, if they have looked for a bottom in the EUR/USD.
As a review, in the FX market, inflation has the potential to strengthen the currency of that economy, which is registering high inflationary levels, since this will cause the bank of that country to increase rates and make it more attractive. that currency.
We left out currencies and now focus on stocks. Here, unlike what we see in FX, we will only have to focus mainly on inflation in the country where the shares are listed.
For example, if we are interested in trading Nikkei-traded stocks, we most likely will not have to pay as much attention to how inflation is developing in Australia.
Regarding this class of assets, the inflationary effects affect in general terms in the following way. As inflation rises significantly, and the central bank raises rates to mitigate price increases, this ends up causing, in the first instance, the economic activity in that country to be affected downwards and, therefore, affecting business. Second, the future valuation of that company is going to have to be discounted at a higher cost, making a stock worth less at current prices. This last phenomenon is linked to the activity of the bonds, since these determine the cost at which future cash flows will be discounted, but we will leave this for the next section.
Here I would like to elaborate on the last point, since this has been one of the factors why technology companies have been the most affected recently in terms of fears of higher interest rates.
Company Valuation Example:
Suppose we have two companies, one that sells innovative software and one that sells doors.
Puertas is a company that has been listed since 1970 with a stable business and which expects to generate $1,000 dollars over the next 10 years with an annual generation of $100 per year.
Software is a company that has just started operations and which expects to generate $1000 dollars during the next 10 years, although during the first 5 there will be no income, while in the last 5 years the income will be 200 dollars per year.
As we can see, both companies have a similar projection regarding the generation of wealth during the same time horizon, although in a different way regarding how the income will be presented. In a world where the cost of money is 0.00%, both companies can be said to be worth $1,000.
However, if the financial conditions become more difficult, and now the cost of money is 10%, the present value of Doors is now $614.4, while Software's is now $470.7. This is the result of the fact that the Software flows are presented more in the future and these, under the money value formulas, register a greater discount to present value.
This is how we have seen that the Nasdaq 100 has suffered losses at a higher level than those that have occurred in the S&P 500.
Regarding bonds, given the lower exposure of the retail public to this branch of financial instruments, we will keep the explanation brief here.
These, when there are inflationary pressures, given that the coupons of the bond are fixed (hence fixed income), the prices of the bonds tend to operate downwards with the expectation of compensating investors with a higher yield.
Here one of the phrases that is most commonly presented when talking about bonds is the inverse relationship in terms of their price and the performance that they offer.
To finish, we will talk a little about raw materials, and more specifically regarding precious metals, since these tend to be considered as protection instruments in periods of inflation.
It most likely comes as no surprise to learn that gold is known to be a valuable metal which has held that status for over thousands of years. As a mere example, since long ago during the time of the Egyptians (+3000 BC) this metal was honored as a valuable object.
Therefore, when there are periods of high inflation, where virtually current money loses value, gold tends to be known for its safe haven and value-preserving abilities.
One of the factors that must be taken into consideration when investing in gold is the comparative factor with other security assets. Here, more specifically, it is necessary to consider what is offered by the instruments that grant returns and that are known as security (Bonds).
If at the end of the day bonds offer positive real returns (Nominal Yield – Inflation), this will most likely cause people to think twice about buying assets like gold which do not generate any return.
To the benefit of gold, over the past few years real yields have been broadly low to some extent and negative areas, so this has been a considerable supportive factor for gold. However, looking ahead and with bond yields advancing, this could shift the balance of attractiveness towards other types of safety instruments.
There you have it, a guide to how inflation affects all major financial assets globally. With this in mind, remember that Pepperstone offers access to all of these financial products.
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Quasar Elizundia is a Markets Analyst for Pepperstone. Over the years, and having worked on the research desks of IG Group and FXCM, Quasar has gained solid experience in the world of trading. With a Bachelor's Degree in International Business, a Master's Degree in Investment and Capital Markets, a Master's Degree in Finance, and as a candidate for the CMT designation, Mr. Elizundia offers a strong perspective on how markets are evolving and how, with an analysis proper technical, traders can benefit.