How Should Inflation Affect Your Investment Strategy?

Inflation is starting to tick higher, and many experts think this could be just the beginning. In this Fool Live video clip, recorded on May 24, Fool.com contributor Matt Frankel, CFP, and Industry Focus host Jason Moser discuss what this could mean for your portfolio, what type of stocks tend to perform best in inflationary environments, and what's causing the inflation we've been seeing. 

Jason Moser: Let's talk a little bit first about inflation, where we things could be headed, and what that could mean for investors. Because generally speaking, when you talk about inflation, that's not something that is clearly detrimental to stocks, but it's absolutely something that can play into growth expectations and performance. Investors need to take this stuff. They need to keep this stuff in mind. As we see the potential here for inflation to start, I'm going to possibly accelerating a little bit here in the coming months and even quarters.

Matt Frankel: Right now, we just saw the April inflation data showed that consumer prices rose a little over 4% year over year, 4.2%. That's definitely above the Fed's 2% inflation target. The question is, are we going to see a short-term bump in inflation due to the reopening? Just a one-time demand rushing into the market, and we see a little inflation all of a sudden. Worse, it can be more of a prolonged trend as they've thrown trillions of dollars of stimulus into the economy. They've been printing money for a couple of years now. Is that going to cause a lot of inflationary pressure on the back end? We've recently saw wage growth is at the highest it's been in a long time, which could also help play into inflation. It's not necessarily a good or bad thing for your stock portfolio. It depends what you're investing in. The traditional hedge against inflation is always thought to be gold or silver, precious metals, things like that. Which to be fair to do a pretty good job of keeping up with inflation overtime, not much more, but they do hedge against inflation. We'll get into the cryptocurrencies in a minute and I'm sure Jason has an opinion on it as I do, but as far as the stock market goes, if you're worried about inflation, the best advice I can give is stick with companies that have a lot of pricing power.

Moser: yeah.

Frankel: For example, if consumer prices rise by 10%, Apple (AAPL -1.75%) has the ability to raise the price of their iPhone by 10% and people are still going to buy it.

Moser: Yeah.

Frankel: There are industries that are a lot more competitive, don't have quite as much pricing power. So that's one thing to ask yourself. If inflation really picks up, what companies will be able to take advantage of the increases in prices? Being that this is the financial show, banks are somewhat inflation protected because inflation generally comes with rising interest rates.

Moser: Yeah.

Frankel: Which if you are a business that lends money, that's a good thing. It's a fine balance between supply and demand. If inflation stays at four percent like it is now, which is a pretty elevated rate, that could be a good thing for banks if rates tend to tick up. If inflation jumps to 10%, and interest rates really skyrocket out of control, that will hurt consumer demand and it's bad for banks. Banks are what I call a moderate inflation hedge. They tend to do well in periods of decent but controlled inflation. Then there are the big box stores and the dollar stores and things like that that tend to be pretty well during inflationary times. Because if you're going to go grocery shopping, for example, you're not going to get much cheaper than Walmart (WMT 0.18%) or Costco (COST -0.17%).

Moser: Yeah.

Frankel: Those tend to get people spending money no matter what the economy is doing. It's not necessarily that you need to be out-of-stocks and into gold, silver, or cryptocurrencies if you believe inflation is really going to stay elevated for a while. It's just to make sure you focus on the right companies that won't get crushed in an inflationary environment.

Moser: Yeah. I think you're right there and inflation, it's an interesting thing to observe because one of the things that stands out to me just recently or at least, looking at last week through the earnings releases and the calls for Home Depot (HD -0.57%) and Lowe's (LOW -0.48%) in the theme over the past couple of quarters. If you've been anywhere near the housing market then you probably know this, but lumber prices have really taken off. Lumber prices have really taken off and what you see in the language in these calls is that while Home Depot and Lowe's are able to continue selling that lumber because they typically have to, that's that's a unique market, they do start to recognize some gross margin pressure from that lumber. They can only price it so much. They can only realize so much pricing power on something like a lumber before it starts to cap out and you see a little bit of gross margin pressure there. To me, that was one thing that stood out. But I also, I wonder, in regard to inflation, it seems like right now, we've got a lot of interesting things going on. We've got the economy reopening, we've got a lot of stimulus out there, we've got folks who should have, in theory, some money to spend, it sounds like, but we've also seen a supply chain crunch. I'm not talking about just semiconductors either. This really does seem to be extending across all areas of the economy. There are just some supply chain issues that are playing out. When you start to have a limited supply of things and you've got a surplus of the hot dollar, surplus of money out there for people to be spending, those are the conditions that inflation just loves.

Frankel: For sure. We're definitely seeing a supply chain crunch. That's why the lumber market is going so crazy. A lot of that is supply chain. So yeah, that also can create inflationary pressures. Like you said, there are certain things where there isn't that much pricing power. You can only raise prices on lumber so much before people are going to stop building decks on their house and pump the brakes on unnecessary spending. But at the same time, I think like milk, the price of milk can double and people are still going to buy.

Moser: Yeah.

Frankel: The price of gas could double, which it almost has from the past year, the price of gas could double and people are still going to fill their tanks up.

Moser: Yeah.

Frankel: There are a lot of industries that do have a lot of pricing power. You'll see demand bend a little bit, but demand is a lot more flexible in some industries and others.

Moser: Yeah. Relatively elastic, I'd say. It's just, it's not going to really change much. The gas is a perfect example there. There was an interesting data point I was reading when I was reading through this piece and it just struck me that this is why we talk about it. This data right here from early 1973 through last December, that stocks deliver positive inflation adjusted returns in 90% of rolling 12-month periods that occurred when inflation was below three percent and rising. Now, that number, 90%, falls to 48% during periods of time when inflation was above three percent and rising. For those who asked, why are we talking about this? That's why we're talking about it because there is data out there that shows it does matter. You have to be maybe a little bit more picky when it comes to your stock purchases.