 Welcome, traders, to today's special presentation on inflation, investing and trading presented by me, Patrick Munnerly. Before we jump into today's presentation, I always want to adhere to the risk disclaimer and specifically with respect to today's content. The views and information or opinions expressed by me are solely mine, they're not indicative or representative of those held by Tickmill UK or Tickmill Europe Limited. Okay, so let's get going here. Inflation. Well, what do we need to know? Inflation measures the rate at which the purchasing power of money erodes over time. Money acts as a unit of account, a medium of exchange and as a store of value. As a store of value, money's purchasing power is entirely dependent on price levels. As price levels inflate, each unit of money becomes increasingly less valuable. Money isn't unique as a store of value. People often choose to hold wealth in other assets like stocks, bonds and property. However, these assets generally have to be converted into money before that wealth can be exchanged for goods and services. The negative effects of inflation are easy to see, the loss of real income, income measured as a collection of goods and services rather than a normal currency amount. For those on a fixed income, it's particularly pronounced. Moreover, because people need to hold some wealth in money for transactions and unforeseen expenditures, inflation ultimately acts to diminish this portion of wealth until wages increase. On the upside, however, stable levels of inflation are correlated with lower unemployment. This could be because expected higher prices stimulate business investment, or because the demand for consumer goods and services has surged. Additionally, many economists argue a low level of inflation between one 3% is needed for monetary policy to be effective. Lastly, borrowers stand to benefit from inflation when holding fixed interest rate loans. Higher inflation means a lower real cost of borrowing. So, what's the impact of inflation on the stock market? Unfortunately, the relationship between inflation and equity prices is not straightforward, and there is no capsule rule that can be applied. A prudent investment or trading strategy would require a thorough analysis of the specific characteristics of each stock under review. With that said, prevailing wisdom indicates that there are certain guidelines that can help in such analysis. So, what's the impact of inflation on stocks in the long run? Well, for stock investors, shares can act as a hedge against inflation in the long run. This means that the monetary value of a stock or share portfolio can appreciate over an inflationary period, so that the real wealth it stores, the goods or services it can be exchanged for, remains constant despite higher prices. In the case where inflation stems from higher input costs known as push inflation, for example, once businesses have had enough time to adapt to the inflation pressures and to adjust their own prices, revenues will increase and nominal profits rates may resume. The higher input costs are simply passed on to consumers after a period of price revision. The economic logic here would also imply that this is probably more realistic for a well-diversified portfolio rather than individual stocks that carry idiosyncratic risks. Inflation impacts on stocks in the short run are slightly different. Analysts suggest that the short-term dynamic is less favorable and that the relationship between equity prices and inflation is quite frequently an inverse correlation, i.e. as inflation rises, stock prices fall, or as inflation falls, stock prices rise. The adverse effect of inflation on stock prices in the short term could result from a range of factors, including falling short-term revenues and profits, creating a drag on share prices, a general economic slowdown resulting in an unfavorable macroeconomic environment for the stock market and consumer spending in general. A monetary policy response that includes higher short-term interest rates causing investors to substitute stocks for lower price bonds. The prospect of a lower or even negative real return lowering the demand for equity investments. In inflationary environments, investors need to make a higher return from the stock portfolio to ensure positive real returns, because, for example, if you make a gain of 4% for your portfolio on an annual basis, that's a real return of 3% when inflation is at 1%, but if inflation was to rise to 5%, you'd actually make a negative real return. Theories addressing the negative correlation between inflation and stocks also argue that, as equity prices are determined by the market's estimate of the stock's value, the lower demand could possibly be a byproduct of market participants' equity valuation models. To understand this better, it's important to touch on a widely used valuation technique appearing throughout the world of finance, discounting expected future cash flows to their respective present value. So let's take a closer look at this valuation model. The present value equals the future cash flow, which you see, divided by an appropriate interest rate. The interest rate is often referred to as the discount rate. So let's say, for example, you stock as a cash flow of £100 for an annual basis, and a discount rate of 5% equals a present value of about £95.24. This is the important takeaway. The larger the discount rate, the smaller the present value. The present value of a cash flow of £100 five years from now at a 5% discount rate is about £78.35. Further into the future, the flow, the lower the present value. So the question of the correct discount value is of vital importance, and it's here that inflation comes into the picture. If the inflation rate is used as an input in determining the discount rate, then a higher inflation rate will cause a higher discount rate. For example, consider a stock that pays a stable dividend at a predictable and regular intervals. In this case, the value of the stock could be reduced to the sum of all future dividend payments and discounted to the present value. The reasoning is the basis of the dividend discount model. When using the dividend discount model, the higher inflation adjusted discount rate acts to diminish the present value of each expected future dividend more than it would before inflation. This in turn lowers the current price of the stock. So what are the stocks to watch during an inflation environment? Well, value stocks have a tendency to outperform growth and income stocks in the short-term during periods of inflation. However, your response to an increased rate of inflation turns on whether you're taking a longer or short-term view. As a long-term investor, you can hedge against inflation and protect the value of your stored wealth by allowing your portfolio to pass increased costs onto consumers over time. For shorter-term traders taking a short-term view, there is evidence to suggest that higher inflation also tends to lead to increased stock market volatility, creating opportunities for either buying or shorting single-name stocks. The performance of value stocks during inflation suggests that the value of stocks are preferred by investors when inflation is high. Value stocks are shares that have a higher intrinsic value than their current trading price. They are frequently shares of mature, well-established companies with strong, current-free cash flow that may diminish over time. But during periods of high inflation, shares associated with larger current cash flows are more valuable than growth stocks that promise distant returns. This could be due to the effect of compounding the discount rates in the present value formula. When valuing equity in terms of discounting future cash flows, sizeable current cash flows will be less diminished than cash flows of comparable amounts further down the road. For example, again, that £100 in one-year discounted out of 5% is worth £95.24 today. But the same cash flow in five years is only worth £78.35. So let's consider the performance of growth stocks during high inflation. Well, research indicates that growth stocks drop in price during high inflation. Growth stocks are shares that will not show strong current-free cash flows or dividend payouts. This demonstrates the potential to outperform the market in the future. They are long-term investments and worthwhile returns can only be expected after they have had a chance to mature and consistently produce better than average results. When discounting growth stocks to present value, the fact that the expected cash flows are still some time ahead means that the compounded discount rate will adversely impact the current share price. We can also consider the performance of income stocks during high inflation because income stocks pay regular and stable dividends, which may not keep up with inflation in the short run. Their price will decline until the dividends rise to meet inflation. International companies may also experience falling share prices when inflation increases. If a company raises prices too much, it runs the risk of becoming uncompetitive if foreign players operate in the same market. So how can we hedge against inflation? Well, as inflation erodes the store of wealth in each unit of money, hedging against inflation is an attempt to move wealth into assets that resist depreciation or, in the best-case scenario, actually appreciates at a higher rate than inflation. When looking to hedge, there are a few options we can consider. A well-diversified stock portfolio can act as a hedge in the long run if companies are able to adjust to higher input costs by raising their own prices by switching to an alternative input. Should this incur, revenues and free cash flow will rise as will dividends. With inflation-adjusted flows and dividends back to normal real levels, share prices can appreciate to reflect the higher valuation. We can also consider commodities. They are a traditional inflation hedge and gold is often used as a safe haven for wealth during inflationary periods. However, several factors have to be considered before assuming commodities will outperform other possible assets. A good way to gain exposure to commodity markets is through ETFs or exchange trading funds that compromise of a basket of different stocks. We can also consider real estate investment trusts or REITs. They are a possible hedge option as real estate prices and rental prices are highly responsive to inflation. Analysts show that returns on real estate has consistently proven to be resilient to surges in consumer price levels. In fact, real estate returns have been similar to stock market returns, but with lower volatility and less signal quality. A REIT is a pool of real estate assets that distributes dividends earned from income-producing property to trust shareholders. In the short term for traders, short-selling stocks can act as a hedge if market demand for stocks fall while inflation rises. Growth stocks and income stocks may suffer a diminished price, owning to decrease present value of dividends and free future cash flows. I hope that has given you an insight into how inflation impacts both investment and trading on the stock market and how we can look to hedge against inflation. Certainly, we can consider trading through the Tick Mill platform where we have access to commodities to some of those ETFs I've mentioned, but also more importantly those single stock names where we can trade in and out to protect our portfolios. If you have any questions or comments, feel free to drop me an email at patrick.money at tickmillpartners.com and I'll come back to you. And if you have any ideas or interest in future topics for us to discuss in these presentations, also happy to receive those. And as always, traders, plan the trade, trade the plan, and most importantly, manage your risk. Until next time, thanks very much.