Over recent months, inflation has become a hot topic not just in financial markets, but across the wider community as consumers across the world face higher costs for a range of goods. 

Inflation levels in the US are tracking at their highest levels in more than three decades. In the UK, inflation has touched a ten-year high. Locally, core inflation hit a six-year high during the third-quarter. On the back of these readings, a number of observers are questioning whether higher inflation could be here to stay.

Central banks often have a key policy tool at their disposal to fight high inflation – lifting interest rates. For much of the last two years, the world has seen interest rates at rock-bottom levels. For investors, it has been a key catalyst that has sparked a near unprecedented stock market rally. However, if policy reverses course, how might that impact the stock market?

How does the market perform during inflationary periods?

Although some onlookers associate high inflation and rising rates with lower returns, the correlation is far more complex. 

Over the short-term, stocks may be hit amid a rotation into more defensive assets amid anticipation interest rates will affect future valuations, impact on near-term revenue, and the prospect of economic growth moderating. 

However, over the long-run, there may be a tailwind for certain sectors, namely profitable businesses or ‘value stocks’ with a high proportion of fixed costs and that hold pricing power – provided, of course, inflation and rate movements are flagged well in advance and controlled. 

Often, the view is that ‘value’ stocks tend to outperform growth stocks and income shares during periods of high inflation. This is because shares tied to larger and more certain cash flows in the near-term are viewed more favourably than distant and uncertain returns from growth stocks in the future, while dividends from income shares might struggle to keep pace with inflation. 

Data from investment management giant BlackRock going back as far as 1927 suggests “value has outperformed growth by the largest margin in periods of moderate to high inflation”.

Closer to home, the ASX has typically performed above its long-term average during each of the last eight instances where rates began a new cycle of increases. 

With this in mind, let’s take a look at some of the popular ‘inflation trades’.

Gold stocks

Precious metals are often viewed as a store of value and a hedge against inflation. While many investors favour direct exposure to gold in anticipation gold prices might rally amid higher inflation, some individuals turn to gold producers as an alternative.

Direct investment in gold may be achieved through a number of exchange-traded funds, which offers a direct correlation in terms of performance with the price of gold. While gold producers also stand to benefit from higher gold prices, they are considerably more volatile owing to operational performance, foreign exchange rates, and highly-leveraged balance sheets.

In the last week, gold prices have touched a five-month high. The asset has gained traction as investors eye ‘safety’ from higher inflation, something that may force central bank officials to lift interest rates in an effort to ‘slow’ the economy. 

Net bullish wagers on gold across Wall Street are at their highest level since the start of the year,  while the flattening yield curve is another sign some market-makers see the Federal Reserve lifting interest rates faster-than-expected.

Our guide on how to invest in gold on the ASX includes several local investment possibilities, but there are also US-listed options such as Barrick Gold (NYSE: GOLD), Newmont (NYSE: NEM) and the world’s largest physically-backed gold ETF in SPDR Gold Shares (NYSE: GLD).

Read this next: A Beginner’s Guide to Exchange Traded Funds (ETFs)

Banks and insurers

Earlier this week, Commonwealth Bank (ASX: CBA) stunned the market with its worst single-day performance since the market crash of March, 2020. Down more than 8% in Wednesday’s trading session, the drop came on the back of dwindling margins as interest rates sit at rock-bottom levels and the mortgage market is awash with competition.

However, if higher inflation prompts a rethink on interest rates, banks typically stand to benefit from larger profit margins during an upwards rate cycle. Some observers point to a larger risk of bad debts, and diminishing appetite for lending as rates increase. These factors need to be considered, however, the sector is typically a net beneficiary under such an environment, and global banks have been unwinding provisions over the last year as worst-case scenarios around defaults did not play out.

On a similar note, insurers also tend to see a net positive come out of a higher interest rate environment. This is because insurers tend to benefit from pricing tailwinds, and also own significant bond investments on their balance sheets that earn a relatively higher rate of return compared with a low-rate environment. 

Energy players

Typically when rates have risen, the sectors that have fared best are those tied to economically-sensitive names. The energy sector is one that shares a direct link to inflation given it is measured as part of the price indices. In recent months, leaping energy prices have played a central role in driving inflation higher. Soaring energy demand has been a result of the global economy reopening from lockdowns, however, supply-side constraints have also fuelled the rally.

In data spanning between 1973 and 2020, the US energy sector has been the best-performing sector during high and rising inflation environments. Firms from this sector have beaten inflation 71% of the time and delivered an average annual real return of 9% per annum.

While crude oil and LNG prices have hit highs in recent months, ASX-listed names in this space, and even some players in overseas markets have underperformed as the future outlook for oil and gas demand faces a challenge amid the transition to renewable energy. 

Whether energy stocks play catch-up and track historical trends during periods of higher inflation, or trade in line with current ‘soft’ sentiment remains to be seen. Nonetheless, these companies have a direct exposure to soaring prices. 

Value stocks amid the rotation

Higher inflation and the prospect of increasing interest rates has historically driven a rotation out of certain companies. Among those vulnerable have typically been highly-leveraged companies with a lot of debt on their books, which compounds as interest rates rise. 

Similarly, in the short-term, yield stocks shed some of their attraction compared with risk-free returns on offer from higher interest rates and the relative safety of economically-sensitive stocks like Woolworths (ASX: WOW), Coles (ASX: COL) and Costco (NASDAQ: COST), which can each pass on higher costs directly to consumers.

There is also some argument that consumer discretionary names, with less scope to pass on higher costs than consumer staple names without shedding business, see headwinds as inflation bites. We have already heard warnings on this from the likes of Domino’s (ASX: DMP). 

Furthermore, if rates rise in response to inflation, this has the potential to divert discretionary spending towards higher loan repayments and constrain revenue growth for retailers that have seen a trading boom over the last 18 months amid unprecedented government stimulus.

In the US, there have been eight periods across the last 100 years where the US CPI has exceeded 5% for over a year. Value stocks held within the BetaShares Global Quality Leaders ETF (ASX: QLTY) have outperformed the S&P 500 in six of these instances, owing to their high profit margins, pricing power, strong balance sheets and subdued valuation risk. 

Last but not least, growth stocks have long been viewed as more susceptible to the whims of higher rates. However, the story has changed considerably in recent times, in part led by the resilience of top-tier tech names like Apple (NASDAQ: AAPL) and Amazon (NASDAQ: AMZN) that have often swayed sentiment across the rest of the growth sector.