Can Stocks Protect Us Against Inflation?

Often, when you ask an investor what his objective of investing is, his answer will be somewhere along the lines of “hedging against inflation”.

This means that the investor wants to ensure that his money is able to give him the same purchasing power despite the ever-increasing cost of living.

So what then can an astute investor do to protect against inflation?

Historically, gold used to be an asset that people believed was the perfect hedge against inflation. But research has shown that there is no direct link between gold and inflation prices.

There is one asset, though, that may come closer to hedging against inflation, and that is equities. This is because some businesses can benefit from inflation in a multitude of ways.

Here, we will look at three areas where equities can benefit from inflation.

Pricing power

When inflation occurs, companies that sell to consumers are able to price their products higher knowing that overall market prices have increased. This means they are able to generate higher revenues despite selling the same amount of products or services.

Gap between cost pressures and pricing power

Inflation, however, works both ways. It not only affects revenue, but it also affects the cost of operation.

One of the cost pressures that occur during inflation is the cost of manpower. This is because as inflation occurs, workers demand more compensation to tide them through the higher cost of living.

Having said that, not all jobs increase pay at the same rate. In the past, less skilled workers have seen their wages rise at a slower rate than their highly skilled counterparts. Companies that depend mostly on lower skilled workers can benefit as cost pressures are less pronounced. Together with pricing power, they will be able to increase profit margins.

Nominal spending power of the consumer

As wages increase, the nominal spending power of the average worker increases too. This naturally means they can spend nominally more on goods and services. This is good for business because if consumers have greater spending power, companies can raise prices and still have sufficient demand.

The Foolish bottom line

Inflation is usually bad for the worker as wages do not rise at an equal or faster rate than inflation. On the flip side, inflation can be good for businesses and investors. Inflation may not affect every business in the same way, but companies that can balance the cost pressures with increasing pricing power might be able to benefit.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Jeremy Chia doesn't own shares in any companies mentioned.