August 1, 2021
Over the past months, I’ve engaged in some informal Stock Talks on the impact of inflation in the stock market and whether or not having cash is a bad thing. I’m curious to hear what others think.
One of my good friends and a reader of this blog sends me a message about once a month that more or less says, “We are in trouble! Why are we holding cash? Inflation is going to be really high”. I usually reply with, “I’m not sure we are in trouble, we might be better off holding cash”.
Here are some of my thoughts on the topic of inflation:
Yes, there is and there will very likely be higher inflation. We just need to look at the grocery bill, cost of gas or housing prices to see that is happening. Furthermore, I believe that the CPI (consumer price index) and PCE (personal consumption expenditure) indices, the metrics used in Canada and the US to measure inflation, will continue to surpass the 2% annual target. Not just vs. last year but annualized vs. 2 years ago.
The Bank of Canada (BoC) and Federal Reserve (Fed) will be forced to change their accomodative monetary policy stance; specifically, when it comes to interest rates. Both (BoC and Fed) have already moved up their target date to raise interest rates. The BoC from 2023 to late 2022 and the Fed from 2024 to 2023
I’m not sure they can even wait that long before intervening. I would not be surprised if the BOC and Fed announce, before the end of this year, a rate hike coming in early 2022.
So what is the ripple effect if interest rates indeed go up?
When interest rates go up, borrowing money will become more expensive for companies. Consumers will also be more cautious with their spending. In turn, company earnings will be impacted (unless you are a bank)
People that have been trading on margin will likely have to sell stocks to pay off their loans. This may have an outsized effect on stocks that are popular with Robinhood traders and others new to margin trading
Some investors will look at shifting money from stocks to fixed income as the risk free rate (i.e. treasury bills) goes up
All of the above will have a further ripple effect in the stock market hurting stock prices and in return, creating opportunities to buy. A drop in stock prices is not necessarily a bad thing if you have cash in reserve to ‘buy the dip’. This also means you will have to be ready to buy when everyone else is selling- something that can be easier said than done- this is where having a preset buy strategy with limit orders will help remove some of the emotion of going against the masses.
The flip side of the coin is that the BoC and Fed do follow through on waiting to take interest rates up. They will probably only do that if inflation is under control (below 2-3% on an annualized basis). In which case, cash would have not lost much value but you might feel left out for not participating more strongly in the stock market frenzy.
Here is an excerpt on this topic from The Economist that an avid StockTalk reader (okay, my brother-in-law) shared this month. I think it summarizes the risk of inflation/interest rate hikes pretty well:
“Inflation has the potential to up-end asset markets. The sky-high prices of stocks, bonds, houses and even cryptocurrency rests on the assumption that interest rates will stay low for a long time. That assumption makes sense only if central banks do not feel forced to raise them to fight inflation. If prices rise too persistently, the financial edifice that has been built on years of low inflation could lose its foundations.”
Claudia Soler
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