What UK stocks and shares would I buy if inflation is coming?

With inflation running above the central bank’s target and expected to keep rising in 2021, what stocks, if any, would I buy?

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Inflation is not coming. It is already here. The last high point for UK inflation was 2.8% in the second quarter of 2017. Since that high point, it had been trending lower and averaged 1% during 2020. In 2021, inflation has shot up to 2.1% in the second quarter. The Bank of England has warned that inflation could hit 4% by the end of 2021. I should be rushing out to find the best stocks for inflation right now, shouldn’t I?

Before I rush out and turn my Stocks and Shares ISA into a giant bet on rampant inflation, I need to consider a few things. First is rampant inflation on the cards? Second, do stocks actually work to protect against inflation, and if so, which ones do the best?

Is an inflation crisis coming?

The global economy is recovering from the coronavirus pandemic. Fiscal and monetary policy is loose, demand has shot up, and supply chains are struggling to meet it. Although expectations are for higher levels of inflation this year, policymakers at the UK’s central bank also believe that inflation will fall back down in 2022. In three years, they think it will sit around the 1.88% mark.

Inflation higher than the UK’s central banks target of 2% is expected to be short-lived. Major central banks are in no hurry to tighten monetary policy. They believe that the spike in demand is temporary, and supply chains will sort themselves out. Also, fiscal stimulus is likely to taper off, which should slow inflation without rapidly raising interest rates.

Can stocks beat inflation?

So how do stocks behave in different inflation environments? Here I draw on some excellent work by Nicolas Rabener, which was published in the Enterprising Investor. He looked back all the way to 1947 and created four inflation regimes: less than 0% (deflation), 0%-5% inflation (low), 5%-10% inflation (moderate), and greater than 10% inflation (high). Then real (inflation-adjusted) US stock returns in each regime were analysed.

Across the four inflation regimes, the average monthly real US stock market return was around 0.9% for deflationary and low inflation environments. Moderate inflation dropped the average to 0.4%, and high inflation pushed average monthly real returns close to zero at 0.1%. These results suggest that stocks do not protect against inflation; the higher it goes, the lower the real stock returns.

If I assume that UK markets will behave similarly to US ones, then inflation above 5% is bad for stocks in general. Now, inflation is expected to top out at 4% here, so perhaps I need not be concerned. But, say it does go over that, or stocks respond worse than expected. Are there some stocks that perform better in higher inflation environments?

What stocks work in inflation

Consumer goods and services stocks fared the worst in moderate and high inflation environments. That’s perhaps a sign that consumers get more price-sensitive when inflation is high. The best performers were oil & gas and mining companies. These appear to do better than expected when the price of the commodities they extract is rising. So, companies like Rio TintoAnglo American, and BP might be good picks for inflation.

However, I pick stocks for their long-term potential; if they do well in inflation, that’s great, but I won’t be drastically altering my stock portfolio just because a short-lived inflation blip is expected.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

James J. McCombie owns shares in Anglo American and BP. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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