Inflation vs. Deflation: What’s the Outlook for US Stocks?

By Kirsteen Mackay

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Inflation refers to the rising price of goods and services in an economy. While deflation is an ongoing decline in prices for goods and services, denoted by an inflation rate falling below 0%.

inflation-vs-deflation.
Inflation vs. Deflation

Inflation fears are mounting as it can no longer be denied that signs of inflation are all around us. Energy, food and housing prices are soaring, along with the cost of new and used cars and discretionary goods. But some camps still believe inflation is transitory, and later this year, we'll see a deflationary environment rather than an inflationary one. Neither is particularly bullish for stocks, but some stocks will do well even in the worst market conditions. We just need to know where to look.

Cathie Wood pounds the table on deflation

Retail investor favorite Cathie Wood strongly believes we are marching towards a deflationary environment. The matriarch of ARK Invest has built her bold investment thesis on the premise of technological advancements and retains it with conviction. 

Her fund inflows soared in 2020 as her bets on disruptive innovation paid off. Things have cooled considerably in recent months, with innovation fund ARKK down 34% in the past six months and genomics fund ARKG down 38% in the same period.

Nevertheless, Wood believes deflation is likely because technologically enabled innovation is a deflationary force, and there are clear signs it's upon us.

In October, she tweeted her deflationary thesis in response to Jack Dorsey’s claims we’re headed for hyperinflation. Their opposing contrarian views add to the confusion surrounding the markets.

This was further backed up by ARK’s December note on innovation stocks being in deep value territory.

Who will be proved correct remains to be seen. Nevertheless, we’ve been in a low-interest-rate environment for over a decade, and with the insane money printing that’s gone on in the past two years, it’s obvious something’s got to give.

What will investors use as an inflation hedge in 2022?

In recent weeks the Fed has turned hawkish intimating it will begin raising rates as soon as March. And Goldman Sachs (NYSE: GS) now sees the Fed raising rates four times this year in response to rising inflation.

When rates rise, costs to consumers and businesses rise. This means profit margins are squeezed, and share prices are likely to fall.

For investors, the traditional hedge was gold or precious metals and commodities. But gold has fallen out of favor in recent years, partly due to the rise of crypto. Indeed, many fans of Bitcoin believe gold’s days are numbered. Nevertheless, plenty of gold bugs still believe it will come good in time and are happy to hold gold as a portfolio hedge.

Meanwhile, oil companies are suffering as ESG mandates move investment from the sector, but oil prices are soaring as demand prevails. So, some investors are turning to oil and gas stocks as an inflationary hedge. 

Meanwhile, some parties believe the Fed raising rates multiple times in quick succession will burst the inflation bubble and result in deflation.

If Wood is right and deflation is the real adversary here, AI stocks could prove a promising hedge. She believes AI will touch and transform every sector, industry, and company during the next five to ten years.

“According to our current estimates, only one other time in ARK’s history, at the end of 2018, has our research suggested such an optimistic growth potential over the next five-years.”

What could indicate deflation?

When consumers believe the price of something will come down if they wait, they stop spending. Manufacturers then reduce prices to sell off goods, creating a deflationary environment. The COVID-19 pandemic caused widespread supply chain disruption leading the demand for many commodities to far outweigh supply. But as the world returns to normality, supplies will rise again, and prices fall. If supplies of cars, semiconductors, homes (both rental and purchase), and consumer goods increase, then things will eventually even out.

Currently, semiconductors remain in high demand as the world electrifies and EV production soars. But semiconductors are traditionally cyclical, and prices are likely to fall again once supplies are replenished. Indeed, the push is on to ramp up chip production in the coming years, so eventually, the demand will be met or exceeded with supply.

Will inflation or deflation prevail?

As so many factors are at play, it’s hard to predict whether inflation or deflation will prevail.

Political and geopolitical moves will also impact the equity environment, as will consumer sentiment, the job market and changing demographics. Since lockdowns led people to re-evaluate their lives, we’re seeing a mass shift in employees resigning or making demands for higher wages. This is an inflationary push because higher salaries lead to higher business costs being passed onto the consumer.

We are also going through a seismic shift to electrification, and while it comes with many benefits, there could be unforeseen challenges to overcome along the way.

With oil prices rising, demand for EVs may increase, but EVs are not cheaper to run over short distances, as the overall cost is higher. Therefore, buying EVs will be inflationary for low-mileage users and deflationary for those traveling long distances. So far, however, EVs are best designed for shorter distances. Indeed, many rural areas are not equipped with the infrastructure or grid to cope with the onslaught of EVs predicted to hit the markets.  

Why do short-term views dictate market moves?

It may seem strange that stocks experience a mass selloff in response to a short-term viewpoint. This occurs because quant and algorithmic trading largely rule the markets. Indeed according to some estimates, algorithmic trading accounts for roughly 70% of all trading in the US. This percentage rises during periods of heightened volatility. That’s why some moves may seem illogical after the fact. It’s also why investors should never panic sell because a sudden selloff is often rectified with a sharp rebound.

For investors in US stocks, a well-balanced portfolio with a five- to ten-year time horizon is potentially a less risky way to invest than with a short-term outlook.

If you enjoyed reading this, why not read our in-depth reports on ESG investing and Healthcare investing. Or check out our 12 investing themes for 2022.

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IMPORTANT NOTICE AND DISCLAIMER

This article does not provide any financial advice and is not a recommendation to deal in any securities or product. Investments may fall in value and an investor may lose some or all of their investment. Past performance is not an indicator of future performance.

Kirsteen Mackay does not hold any position in the stock(s) and/or financial instrument(s) mentioned in the above article.

Kirsteen Mackay has not been paid to produce this piece by the company or companies mentioned above.

Digitonic Ltd, the owner of ValueTheMarkets.com, does not hold a position or positions in the stock(s) and/or financial instrument(s) mentioned in the above article.

Digitonic Ltd, the owner of ValueTheMarkets.com, has not been paid for the production of this piece by the company or companies mentioned above.

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