Q: Sonia, equities are said to be a good frontline defender against inflation. Why is that, in your opinion?
A: With all the stimulus that has been implemented in the last 12-months. as well as more on the way, inflationary pressures are expected to build. Using history as a guide, equities tend to perform well when inflation is rising, and as economic activity picks up. One reason that stocks are a good hedge is that inflation generally means that the economy is healthy, companies are producing, consumers are making purchases and business employment and wages are strong. Furthermore, corporate revenues and earnings are growing, which provides support for equity prices.
That being said, volatility may pick up over shorter periods as the focus may only be on the reduction of the present value of future earnings, while ignoring the tendency for nominal earnings to grow faster when inflation is higher. Dividend-paying companies that increase their dividend stream on a consistent basis at a rate greater than inflation can provide an additional hedge.
Q: David, what does the empirical evidence suggest about equities and their inflation-fighting abilities?
A: Over a long-term environment of mild 2.5-3.0% inflation rates, U.S. stocks are arguably the best asset to achieve a favorable inflation-adjusted real rate of return. In the current environment, with most investment grade bonds yielding less than 2% and the underlying inflation rate roughly the same, stocks are even more compelling as a favored asset class, relative to bonds, in portfolios for investors seeking a real rate of return.
However, even equities have struggled to generate real rates of return when inflation rates have climbed above 4.5 -5.0%. That was particularly the case from 1965-1982 when the U.S. transitioned from a low inflation and interest rate environment to one of escalating inflation and interest rates. It was only in mid-1982, when investors developed greater conviction regarding the Federal Reserve’s fight on inflation, that stocks resumed their ability to compound at more favorable levels. So, the absolute level of inflation is relevant.
Today, we are witnessing a period of modestly higher interest rates, in part driven by expectations that inflation rates will incrementally move higher. Currently, there is less evidence of a return to inflation rates over 4.0%, which would prove problematic for longer-term stock returns. Interestingly, as inflation does move marginally higher, and interest rates are already reflecting this, value-leaning stocks have historically participated well in this type of macro environment. This is in large part because value stocks tend to have greater sensitivity to better economic conditions and profit growth.
Q: Dan, how do you think about inflation and the impact on businesses and security selection as a small cap investor?
A: Generally, small cap stocks tend to outperform during periods of inflation, principally because inflation can be a symptom of economic growth. More specifically, small cap stocks tend to outperform early in the economic growth cycle because they feel the impact of the renewed growth cycle, in many cases, a little earlier and disproportionately. Most importantly, given there are more than 2,000 companies which can be classified as small cap stocks, there are plenty of opportunities to identify those that will benefit the most from inflation.
The main characteristics of potential winners are companies that possess an intangible asset, e.g., a patent, contract and/or trademark that supports solid pricing power in the event they have to pass along higher input costs, or companies with relatively large inventories that increase in value before being sold. The early signs of some inflation and reemerging economic growth this year have been very positive for small cap stocks. Continued slowly-rising inflation should continue to provide a positive backdrop for small cap stocks.
Q: Michael, as a portfolio manager, how do you think about cyclical opportunities versus longer-term secular growth opportunities in a period of potentially rising inflation?
A: The Fed is certainly getting more and more serious about getting inflation to at least 2% and even higher. If they are successful, and that’s not a certainty, cyclical companies should do well in the early stages of that environment. We are already seeing commodity prices push higher, in some cases much higher. The producers of those commodities are big beneficiaries, while the users of those commodities will likely experience margin compression.
However, as the inflationary environment continues, quality value-added companies, no matter where they are in the production chain, should be able to pass higher input costs to their customers to maintain margins. In the meantime, commodity cyclicals will likely experience increasing costs at some point in the cycle.
So, as a portfolio manager, the core of the portfolios we build consists of quality companies with strong balance sheets that can weather stormy seas. Cyclical companies, which are generally of lower quality (though not always) are more opportunistic investments, in my view.
Q: Jeff, overall what is the mindset of successful long-term investors that helps them overcome inflation fears or other periodic “wall of worry” items?
A: I like to think in terms of investment principles, and it comes back to keeping our focus on what we have control over as investors. Inflation is a predictable and continual process that impacts all investments to varying degrees, and successful investors carefully plan for this. Clearly, if we hope to achieve long-term financial goals, such as a comfortable retirement or college savings for children, we’ll need to create a portfolio of investments that will provide sufficient returns after factoring in the rate of inflation, which is something we’re always considering.
Conducting a review of investments that are most likely to provide returns that outpace inflation is something we do regularly on behalf of clients. But the successful investor mindset remains the same: Proper comprehensive planning underpinning an appropriate portfolio asset allocation, diversification, quality security selection, frequent communication paired with investor education (a remarkable antidote to fear), maintaining a long-term investment strategy and perspective and assiduously avoiding market timing and emotional decision-making.