Everyone seems to be worried about the imminent arrival of higher inflation. So where should we invest if inflation is about to gain traction? I’d look at the UK stock market.
The Motley Fool writer Malcolm Wheatley recently pointed out that it looks like investors have been selling their fixed income bonds and gilts. And that process typically causes their prices to fall and their yields to rise.
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Bonds can be a decent forward-looking economic indicator. In the past, rising bond and gilt yields have presaged rising general prices ahead. So where should we invest if inflation is on its way? One top-of-the-head idea is to look at equities (shares).
Why I’m attracted to the UK stock market
In theory, shares could be attractive because each stock is backed by a real business. And many businesses can raise their selling prices to accommodate higher input costs. If they can maintain their sales, revenue and profits should rise along with inflation and the share price should move higher to compensate as well.
Admittedly, if the rate of inflation gets too high, some businesses may struggle to cope, invest and grow. Moderate inflation, on the other hand, can be good for growth. The government often aims for an inflation target near 2% annually, for example.
That said, historical studies relating inflation to overall stock market performance have thrown up messy results. There are so many interlocking factors to consider that it’s hard to point to a consistent and recurring outcome. However, some sources reckon the evidence shows that value stocks tend to perform best during periods of high inflation. And more expensive growth stocks perform better during periods of low inflation.
And we’ve recently seen something of an investor rotation from pricey growth stocks into better-value recovery stocks. Perhaps that move is another leading indicator suggesting inflation could be on the way.
Value stocks could shine
I like the idea that the value side of the value/growth equation could lead to good investing. It brings to the fore traditional investing skills for analysing stocks and their underlying businesses.
It’s no secret that many of the fast-growing and high-priced growth stocks are to be found in foreign markets such as the US. Here on the London market, we’re more used to value and cyclical businesses. Many times, investors gaze across the pond with envy at the fast stock movements and racy valuations stateside. But lately, I’ve been hearing about foreign investors looking longingly at the juicy bargains in the UK market. And some commentators have been pointing to London as a great place to invest for Covid reopening stocks.
But I think we can add another dimension to the theory. The London market is also probably a promising place to find decent shares to hold as inflation ramps up in the months and years ahead. And for those reasons, I reckon there’s a good chance we’ll see a multi-year UK stock market boom. But, of course, nothing is certain and the UK stock market could even move down instead of up.