INFLATION

INVESTOR'S GUIDE
INFLATION INVESTOR’S GUIDE

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage.
77% of retail investor accounts lose money when trading CFDs with this provider. You should
consider whether you understand how CFDs work and whether you can afford to take the high
risk of losing your money. X-Trade Brokers DM S.A.

This Guide is provided for general information and marketing purposes only. Any opinions,
analyses, prices or other content does not constitute investment advice or a recommendation in
the meaning of the Act of 29 July 2005 on trading in financial instruments.

Past performance is not necessarily indicative of future results, and any person acting on this
information does so entirely at their own risk. XTB will not accept liability for any loss or damage,
including without limitation, any loss of profit, which may arise directly or indirectly from the use
of or reliance on such information.

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INFLATION INVESTOR’S GUIDE

Intro
March 2020 was the shortest bear market in the history of Wall Street due to unprecedented
intervention from the Federal Reserve. The QE policy, informally called “money printing” flooded
markets with cash and encouraged risk taking. At the same time, the record pace of money
creation raises inflation concerns. March US CPI inflation was the highest since August 2018, and
this is only the beginning. In this report, we explain why inflation is so important for the markets,
with a special focus on indices and Gold. You will also learn which inflation measures to track and
what are the key data releases.

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INFLATION INVESTOR’S GUIDE

Why inflation matters

To understand the importance of this report, we need to go back to the spring of 2020 when the
global economy was hit by COVID19 related lockdowns. By then, the potential impact seemed
catastrophic and the market reaction was painfully sharp. Global indices sunk along with
industrial commodities as the US dollar gained. However, it turned out to be the shortest bear
market in the history of Wall Street.

Fed QE vs markets (12/31/2019 = 100)

Fed balance sheet (USD million, RHS) S&P 500 Nasdaq-100 Gold Russell 2000

The massive expansion of the FOMC balance sheet was critical in ending the shortest bear
market on record.

Please be aware that the presented data refers to the past performance data and such is not a reliable indicator of
future performance.

Source: Bloomberg, XTB Research

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The Fed is the primary reason why the worst did not materialise for global markets. As you can
see on the chart, it expanded its balance sheet by record amounts, injecting giant amounts of
cash and allowing the US Treasury to run a large budget deficit. As a result, markets rebounded
quickly and quickly left the pre-pandemic highs in the back mirror. However, despite record
markets and prospects of economic recovery, the Fed keeps expanding the balance sheet at the
pace that was never seen before the COVID19 pandemic. This continues to underpin the global
rally with US indices leading the way. With this in mind, any major change in the Fed policy could
mark an end to this rally.

To find out more about SHORT SELLING click here.

Why would the Fed change the course? They don’t want to, especially with the US government
running series of the largest post-war deficits. The only thing that may come in the way is
inflation. While the Fed officially wants inflation to be higher, very high inflation may force the
central bank to end the QE (called simply “money printing”) policy.

Inflation - know your enemy

Inflation represents price changes over a period of time. Price changes from month to month can
be volatile, so central bankers - and thus investors - look at annual inflation measuring price
changes from a year ago. However, there are many prices: consumer prices, producer prices,
import and export prices, and so on. Central banks are interested in consumer prices, but even
here there are many measures to look at. Let’s focus on the key ones.

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INFLATION INVESTOR’S GUIDE

US inflation measures

CPI y/y CPI Core y/y PCE y/y PCE Core y/y

While the headline CPI inflation draws the most attention, the Fed looks primarily at the PCE
core, which is the least volatile one and very often the lowest.

Please be aware that the presented data refers to the past performance data and such is not a reliable indicator of
future performance.

Source: Macrobond, XTB Research

The Consumer Price Index (known as CPI) is the most popular measure of inflation. It is defined
as a measure of the average change over time in the prices paid by urban consumers for a
representative basket of consumer goods and services (shelter, food, energy, education and so
on). However, the Fed focuses on the Personal Consumption Expenditures Index (known as
PCE). There are 3 key differences between CPI and PCE:

1. CPI weights come from consumer, while PCE weights come from business surveys

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INFLATION INVESTOR’S GUIDE

2. PCE measure is broader

3. CPI has a higher share of shelter and for that reason has been historically higher on
average

Furthermore, both CPI and PCE have “Core” variants that strip out volatile prices of food and
energy. While the Fed targets the PCE, they often treat the PCE core as more reliable.

Remember: CPI and CPI core are treated by investors as the early signals, but the Fed
targets PCE and uses PCE core as a trend gauge - it’s important to watch all four
measures!

Will inflation rise?

The quick answer is YES. However, the issue is more complex than this.

Since the Fed and other central banks are expanding their balance sheets at record pace and
measures of monetary aggregates are exploding, many commentators see these as a sign of
inflation. The reasoning stems from the monetary theory stating that in the short run more money
can only lead to higher prices. But it’s not so simple.

The whole “money printing” cannot be directly spent unless it’s under the disposal of consumers
or government officials. A great example of this is the last recovery, when average monthly core
CPI was actually lower than during a previous recovery (0.13% in 2010-11 vs 0.14% in 2003-04)
despite the introduction of QE. Yes, headline inflation will rise because it was low a year ago with
the biggest difference in fuel prices, but the Fed insists that this rise will be temporary.

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INFLATION INVESTOR’S GUIDE

Could it be different this time around? We do not know for sure, but there are some good reasons:

1. Money transfers are huge - because of direct payments, special unemployment benefits
and other support US households have more money than they would have should the
pandemic never happen!

2. Pent-up demand is strong - consumers were unable to spend on many things they would
like because of restrictions - they may want to over-compensate after the reopening

3. Commodity prices are surging - it’s not just oil. Look at copper, cotton, grains - this is
partly a result of 0% rates as investors are looking at these assets as investments!

4. COVID costs - the economy reopens, but the sanitary regime will stay in place with all its
associated costs

5. There is less competition - some companies were closed, especially in services. Less
competition means a higher pricing power

For those reasons, inflation may rise more and stay higher than the Fed would hope. If this is true,
the US central bank might be forced to limit QE just when the US government needs to borrow
large sums of money. That would drive bond yields much higher and have serious consequences
for other markets.

BOX: Eviction moratorium

Rents represent nearly 33% of CPI and 23% of PCE and even more in the “Core” variants. It is clear
that this category is crucial for the inflation path. Property prices are surging, but will rents follow?
One thing to watch out for is the eviction moratorium,which prevents renters who are behind their
rents from being evicted - it has been extended until the end of June. In theory, once landlords can
evict renters, they could also be willing to increase rents, leading to higher inflation.

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INFLATION INVESTOR’S GUIDE

Indices: free money is everything

Investors often assume that a stronger economy is always good for stocks, because this is what
they read in books. But if a strong economy comes with too high inflation, the outcome can be
very dangerous.

When you compare historical inflation rates and valuation measures, such as price-to-earnings,
there is a clear relationship. At times of higher inflation, stocks were cheaper than during times of
low inflation. This happens for two reasons:

1. Inflation makes future earnings less valuable today

2. Higher inflation usually leads to higher interest rates and investors may prefer bonds or
bank deposits

Stock valuation and PCE inflation

PCE Core Yoy S&P 500/E (RHS, Inverted axis)

The inflation levels have been historically very important for stock valuations.

Please be aware that the presented data refers to the past performance data and such is not a reliable indicator of
future performance.

Source: Macrobond, XTB Research

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INFLATION INVESTOR’S GUIDE

Because indices did so well thanks to the FOMC policy, any change in this regard could have
serious ramifications. Many traditional measures of market valuation, such as price to earnings,
price to revenues or price to GDP, are now higher than ever before. This is partly caused by the
lack of alternatives with zero percent interest rates and low bond yields. Should the monetary
environment change, the arguments for record valuations will no longer be valid.

Selected S&P500 metrics between 1950 and 2019 vs now

minimum median maximum latest

S&P500/GDP ratio 0.031 0.086 0.153 0.193

Margin Debt/GDP 0.003 0.008 0.033 0.038

Price to Earnings 6.836 17.087 30.725 33.615

Price to Sales 0.655 1.520 2.382 3.101

Investor Sentiment -0.540 0.080 0.629 0.365

Margin Debt/GDP - data available since 1954-02

Price to Earnings - data available since 1959-02

Investor Sentiment - data available since 1987-07

Price to Sales - data available since 1990-01

Many measures of stock valuations are now the highest in history.

Please be aware that the presented data refers to the past performance data and such is not a reliable indicator of
future performance.

Source: Macrobond, XTB Research

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INFLATION INVESTOR’S GUIDE

We do not know how much inflation is going to increase and how the Fed will react to it if it’s too
high. Therefore it’s impossible to precisely predict the outlook for indices like US500 or US100.
What we can say right now is that:

1. Many valuation measures are now the highest ever

2. Higher inflation is negative for stock market valuation

3. We saw many 18-20% corrections on the S&P500 in the past

4. Historically instruments representing “value” (like US2000) fared better when inflation
fears persisted compared to “growth” instruments (like US100)

Remember: markets will not wait for the Fed to raise rates. Investors will watch inflation
data to assess if the Fed is able to maintain aggressive monetary policy.

Gold: is the metal a natural

hedge for inflation?
There is a consensus that higher inflation is problematic for stocks, but there’s also a perception
that gold is a good hedge. Is that true? The data remains mixed. On the one hand, it is true that
gold prices strongly increased in the late 70s and early 80s when inflation was very high. However,
a correlation between annual gold prices and annual US inflation has been mixed since then.
Looking at 3-month changes, we have not noticed any significant correlation either.

What is more, we do notice a very strong negative correlation between 3-month price changes
and 3-month 10-year Treasury bond yield changes. This explains why gold prices actually
declined in the first quarter of 2021, when inflation risks started to emerge.

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INFLATION INVESTOR’S GUIDE

Remember: Gold CFDs allow you to take a short position. Short position can result in
gains when gold prices decline and losses when gold prices increase.

Weekly Price Correlation 2000-2021

Global Global
Commodity MSCI Brent FTSE S&P
Gold Treasuries Inflation-linked US TIPS Agriculture
Price Index EM Oil REITs 500
ex US Bonds

Gold 1

Global Treasuries
ex US
0.453 1

Global Inflation
-linked Bonds
0.413 0.807 1

Commodity Price
Index
0.404 0.215 0.301 1

US TIPS 0.233 0.505 0.757 0.121 1

MSCI EM 0.233 0.147 0.253 0.492 0.065 1

Brent Oil 0.21 0.081 0.195 0.758 0.084 0.388 1

Agriculture 0.199 0.115 0.141 0.628 0.012 0.287 0.285 1

FTSE REITs 0.141 0.094 0.222 0.287 0.086 0.531 0.216 0.18 1

S&P 500 0.032 -0.035 0.092 0.359 -0.053 0.702 0.318 0.217 0.687 1

Gold prices enjoy a low long-term correlation with risky assets.

Please be aware that the presented data refers to the past performance data and such is not a reliable indicator of
future performance.

Source: World Gold Council, XTB Research

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INFLATION INVESTOR’S GUIDE

While not exactly a perfect hedge versus inflation, Gold has enjoyed low long-term correlations
with stocks and indices. Low correlation allows for construction of more diversified portfolios.
Therefore, while a period of rising bond yields might be difficult for Gold prices, the metal could be
helpful in a long term risk management of portfolios that have large concentrations of stocks.

Mark these dates

It should be pretty clear by now that inflation should be closely watched in weeks and months
ahead. We have prepared a schedule of key dates until the end of July, covering data releases and
FOMC meetings. The CPI release is always the first one, so investors tend to watch it carefully.
The PCE is usually released about 2 weeks later, but since it’s the key measure for the Fed it
should be watched too. Finally, FOMC meetings will provide great opportunities for the central
bank to respond to rising prices. Bear in mind that more data and news will arrive on the inflation
front, so make sure to track the “News” section in XTB platforms.

FOMC meetings FOMC minutes release

June 15-16 (Tuesday, Wednesday) July 7 (Wednesday), 8:00 pm CEST

July 27-28 (Tuesday, Wednesday) August 18 (Wednesday), 8:00 pm CEST

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INFLATION INVESTOR’S GUIDE

Inflation Data for the month of Release

CPI April May 12 (Wednesday), 2:30 pm CEST

CPI May June 10 (Thursday), 2:30 pm CEST

CPI June July 13 (Tuesday), 2:30 pm CEST

CPI July August 11 (Wednesday), 2:30 pm CEST

PCE April May 28 (Friday), 2:30 pm CEST

PCE May June 25 (Friday), 2:30 pm CEST

PCE June July 30 (Friday), 2:30 pm CEST

PCE July August 27 (Friday), 2:30 pm CEST

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INFLATION INVESTOR’S GUIDE

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage.
77% of retail investor accounts lose money when trading CFDs with this provider. You should
consider whether you understand how CFDs work and whether you can afford to take the high
risk of losing your money. X-Trade Brokers DM S.A.

This Guide is provided for general information and marketing purposes only. Any opinions,
analyses, prices or other content does not constitute investment advice or a recommendation in
the meaning of the Act of 29 July 2005 on trading in financial instruments.

Past performance is not necessarily indicative of future results, and any person acting on this
information does so entirely at their own risk. XTB will not accept liability for any loss or damage,
including without limitation, any loss of profit, which may arise directly or indirectly from the use
of or reliance on such information.

X-Trade Brokers www.xtb.com

www.xtb.com