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Central banks told us that inflation would be ‘transitory’. Instead, inflation is now heading for double digits in Europe and the US – and it’s widely predicted to stay elevated for years. Investing during inflationary times could look very different to the experience of recent decades.
Given the huge quantity of money printing after the financial crisis, and subsequently covid, it became apparent to anyone with a mere sprinkling of common sense that inflation was going to materialise sooner or later.
In the wake of the Great Financial Crisis of 2008-09, inflation manifested itself in asset prices rather than consumer prices, but once governments started handing out checks to people during covid, inflation permeated its way into consumer prices too.
2020 alone saw the US money supply expand by more than 20%.
The trouble – as policymakers have discovered during previous inflationary bouts – is that once the inflation genie is out of the bottle, it is very difficult to put away.
High inflation, if not squashed quickly, can lead to consumers adjusting their expectations of future prices, which in turn leads to higher wage demands, thereby feeding the inflationary spiral.
A high-inflation environment took root following the oil shocks of 1973 and 1979, with inflation running well into double digits.
The early 1980s saw a very painful disinflationary adjustment take place under Paul Volker’s tenure at the Fed, with aggressive rate hikes intended to choke off demand and bring inflationary expectations back into line.
While it is unclear how high rates will need to go in order to tame inflation this time round, what does seem clear is that policymakers will allow inflation to settle at a higher rate in future.
Firstly, it is in policymakers’ interests to allow a higher ‘normal’ rate of inflation to take root that will erode the real value of government debt. We would not be surprised to see central banks adjust their target rates of inflation accordingly in due course.
Second, the disinflationary effects of globalisation are falling away as supply chains reorder themselves and the world bifurcates between competing spheres of influence.
And lastly, the so-called energy transition has led to huge underinvestment in essential conventional energy supplies, which has been laid bare by the current war in Ukraine.
So what is the new normal when it comes to inflation? Financial historian Russell Napier expects inflation to settle into a range of 4-6%, which is much higher than the c. 2% we’ve seen in recent history.
Investors need to think carefully about where to invest during times of inflation. A chief casualty of recent times has been growth stocks, particularly the technology stocks in the US. This makes total sense when you consider that these are long-duration assets, with expectations of greater cash flows further into the future.
In essence, a higher proportion of a growth stock’s value comes from cash flows that are projected way into the future and discounted back to the present using the ‘risk free’ rate (effectively the interest rate on government bonds). As interest rates rise, the discount rate used to calculate a present value for these companies rises too, which means their valuations fall.
Conversely, value stocks will typically generate cashflows and return capital to shareholders faster than a growth stock. This is because, by definition, much of the expected cash flows from value stocks is front-end loaded – i.e. their price-earnings multiple is lower. This means that value stocks can be among the best investments during inflationary times.
In an analysis of growth versus value using data since 1927, Blackrock found that value stocks achieved greatest outperformance in periods of moderate to high inflation. It is only when inflation was very low that value suffered, and that is what we saw in the post-GFC era.
Analysis from BlackRock Risk and Quantitative Analysis has yielded similar results. Value stocks have also tended to perform well amid rising interest rates. Over the past 40 years, a sizable portion of value returns has come during periods of rising rates.
Top performing areas of the stock market during the inflation of the 1970s included:
Energy: Global supply disruptions, including the OPEC oil embargo and the Iranian Revolution, drove oil prices sharply higher and led to significant earnings and cash flow inflections for US producers. This eventually ended with demand destruction in the early 1980s recession. This time round the ESG obsession has delivered a favourable secular backdrop for hydrocarbon producers, which should enjoy higher prices for a sustained period of time as a result of chronic underinvestment. Threats include demand destruction and windfall taxes.
Healthcare: The 1970s saw the pharmaceuticals industry delivered double-digit revenue growth. Because raw materials are a small part of the cost structure, margins were much more stable for the healthcare industry during this inflationary period. Despite the relatively close association with technology, there are numerous value stocks to be found in the healthcare space.
Financials: Banks were largely insulated from inflation. Insurance saw reduced capacity and higher pricing in response to inflation, which drove better returns in the latter part of the period. Banks tend to generate higher margins as interest rates rise.
Real estate: REITs tend to underperform the market when inflation is 2.5% or lower, but handily outperform when inflation is 7% or higher, as it is now. Look for those with short-duration leases that reset to market rates on a frequent basis.
Growth and technology stocks in particular have already been hit hard by the interest-rate hikes from the Fed. As previously alluded to, this stems from the fact that these are ‘long duration’ assets with cashflows weighted well into the future.
The $64 billion question is whether markets have adjusted enough in the face of this high inflation and rising rates environment, or whether there is still some hope that the Fed will ‘pivot’ and stop raising rates – or even begin to reduce rates once again.
Jamie Dimon, CEO of JP Morgan, believes this is wishful thinking:
“There’s too much reliance on central banks to save the day every time something goes wrong. I don’t think we should put the central banks in a position that every time there’s a fluctuation in the market, they have to do something. I don’t think they should have to fix every problem that is out there.”
If we believe that the Fed is serious in its fight against inflation, it is quite plausible that some tech valuations may not return to previous highs for a long time – if at all. If we are witnessing a paradigm shift in the sense of a return to a ‘normal’ level for interest rates, market dynamics could be very different in future to how they have been over the past decade or so.
Dimon, for one, believes that the market could have further to fall in the face of high inflation and higher interest rates:
“It [the S&P 500] may have a way to go [lower]. It could be another easy 20%. The next 20% will be a lot more painful than the first, rates going up another 100 basis points will be a lot more painful than the first 100, because people aren’t used to it.”
Many market participants have never experienced an environment where interest rates have not been close to zero. What’s more, many of them also have a deep-seated bias against the kinds of stocks that perform well in a high inflation environment (e.g., oil & gas, commodities, tobacco etc.).
This presents an opportunity to agile investors.
It is true that gold is an inflation hedge – but only over the very long term – e.g., it takes roughly the same amount of gold to buy a loaf of bread now as it did in Roman times. However, over the short term, gold has an inverse relationship with the strength of the dollar.
The flight to safety has driven the dollar significantly higher on international markets, which has seen a soft gold price (in US dollars). Additionally, the opportunity cost of holding gold is now greater (at least in nominal terms), as interest rates on cash have risen.
However, the Russians and the Chinese have been major buyers of gold in recent years as they hope to establish a rival monetary system to the greenback. The yellow metal could also benefit in the event of some kind of financial or banking crisis precipitated by monetary tightening.
Gold mining stocks have been hit hard due to the weaker gold price as they sell their ounces in international markets priced in dollars. Once dollar strength subsides, this could set the stage for an improvement in gold prices and the operational gearing impact on gold miners could leave valuations looking attractive.
What’s more, many major gold miners need to replenish their resources, which could make the middle and junior tiers of the sector particularly attractive, as they are take-over candidates.
What are the best investments during times of inflation?
Companies with real assets and leverage: Companies with valuable real assets – for example, property – on their balance sheet but also a lot of debt stand to benefit, as the real value of their debt is inflated away whilst the value of their assets increases with inflation.
Companies with pricing power: Pricing power is crucial in an inflationary environment, as companies without the ability to raise prices, at least in line with their costs, will quickly find themselves falling behind. Look for stocks with high barriers to entry, such as the ones mentioned below.
‘Sin’ stocks – oil & gas, mining, tobacco, defence: The so-called sin stocks tend to have high barriers to entry and thus pricing power, which can insulate them from the worst impact of high inflation.
Active managers: Passive investing may not be the best approach in an inflationary environment, as past instances of high inflation have led to a weaker performance of the stock market as a whole. However, there are some sectors and stocks that stand to benefit, and a good active manager should stand a better chance of putting together a portfolio that can outperform in such an environment.
What are the worst investments during times of inflation?
High leverage companies with little to no pricing power: As interest rates rise to combat inflation, those companies that find themselves overleveraged and without the pricing power to maintain margins in the face of higher costs will be caught between a rock and a hard place.
‘Jam tomorrow’ companies: Zero interest rates made concept stocks attractive as the opportunity cost for holding these stocks was low to non-existent. Higher interest rates will make it much harder for these kinds of ‘jam tomorrow’ companies to get funding in future – unless they can demonstrate a clear path to solid returns.
Passive index funds: A rising tide lifts all boats, and this was certainly the case in the decade following the financial crisis. However, an inflationary environment will require investors to be more selective in how they go about putting together a portfolio. The tide could be turning for the index fund revolution.
Disclaimer: This blog is intended for informational purposes only. This blog is not intended to invite, induce or encourage any persons to engage in any investment activities and is not a solicitation or an offer to buy or sell any stock, investment product or other financial instruments. If in doubt, please seek financial advice from an independent financial adviser. Sarnia Asset Management is licensed by the Guernsey Financial Services Commission (GFSC). Past performance is not an indication of future returns. Investments carry risk, including the risk that you will not recover the sum that you invested.
By James Faulkner
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