- Investors are putting too much faith in central banks and zero interest rate policies and ignoring growing inflation.
- High inflation, which translates to higher interest rates, is a major blind spot that could drastically impact all asset prices as investors will change to compensate for lower purchasing power.
- Growth stocks, bonds, and cryptocurrencies will be the biggest losers in a high inflation environment, while commodities, Big Tech and consumer staples will be the biggest winner.
Global markets are partying like it’s 1999, with virtually every asset class near historic highs. With interest rates near zero in a low inflation environment, it appears nothing can spoil this party with meme stocks, cryptocurrencies, and SPACs thrown into the mix.
Short-sellers and doomsayers have been crushed, as Robinhood investors flood the market, driven by pent-up demand from the pandemic and fiscal stimulus from governments in the form of unemployment benefits and cash handouts.
But sharply higher demand and a constrained supply has led to price increases across the board.
In other words, inflation.
Yet, central bankers do not seem overly concerned, signalling that interest rates will remain low for longer. US Federal Reserve chairman Jerome Powell declared that inflation will be “transitory”, a sentiment echoed by his peers.
How economists can predict the future with such clarity and precision remains a mystery to me.
And judging by the upward march in the markets, global investors are taking them at their word.
Businesses, on the other hand, are singing a different tune.
In the most recent Berkshire Hathaway annual shareholder event, dubbed the ‘Woodstock of Capitalism,’ Warren Buffett, who owns a collection of American companies said: “We are seeing very substantial inflation. We are raising prices. People are raising prices to us and it’s being accepted.”
In fact, virtually every major CEO is sounding the alarm on inflation.
This disconnect between central bankers and businesses will shake out in one way or another.
And investors need to be prepared if inflation turns out to be more persistent than the current market is pricing in.
What Does Inflation Mean For Investors?
Inflation doesn’t just mean higher business costs and higher consumer prices. It also creates a higher hurdle rate for making investment decisions.
Currently, with interest rates near zero and low inflation, investors are willing to accept more risk and invest in companies with negative earnings today, in favour of higher growth and the hope that profits will materialise ‘down the line.’
But in the hypothetical scenario of 5% inflation, investors would require a higher return upfront to compensate them for losing 5% in purchasing power each year (compounded annually). This means that they will start evaluating companies based on earnings growth rather than revenue growth, and will look less favourably on companies with 5-10 year runways of negative earnings and cash flows.
Low inflation and low rates had created a virtuous cycle, where investors tolerated more risks, lower upfront returns, on higher valuations.
High inflation, which will also force central banks to raise interest rates to avoid disastrous outcomes like hyperinflation, creates the exact opposite effect – a vicious cycle where investors will demand earnings upfront, faster, and at lower valuations to compensate them for reduced purchasing power.
This cycle will be self-reinforcing, leading to a downward correction in most asset prices.
What Assets Are Most At Risk From Inflation?
The assets which benefited the most from low rates and low inflation will be hurt the most, including:
1. Growth stocks
Specifically, growth stocks that burn a lot of cash and consistently report negative earnings. Some trendy SaaS, IoT and FinTech names come to mind.
If these companies can’t achieve profitability when inflation is low and funding virtually free, they’ll likely never become profitable.
In an inflationary world, if growth at any these companies show even the slightest hint of slowing down, the impact on their stock price will be swift and brutal.
This applies less to Big Tech companies who already have dominant positions and pricing power in their markets. Every company likes to think they’re the next Amazon or Netflix. But most of them are not and never will be.
In making these generous comparisons, they tend to forget that founders like Jeff Bezos shared his plans for profitability all the way back in 1997. In 2020, Netflix earned USD2.76 billion in earnings and printed USD2.4 billion in cash flow from operations.
Ride-sharing companies like Grab and Uber, on the other hand, still aren’t profitable despite dominant market positions and the easiest monetary environment in human history.
Simply put, bonds pay a fixed coupon, which is worth less with higher inflation. The value of bonds is also negatively correlated with interest rates, meaning that if central banks raise rates to tackle inflation, the value of bonds will decrease.
What’s worse, the past decade of low to negative interest rates has created the biggest bond bubble investors have ever seen. There is simply no historical precedent for this.
But the forward expectations for bond values in an inflationary environment is clear, they’ll be worth less. Much less.
Cryptocurrencies have been hailed as the alternative to fiat money and protection against the devaluation of the dollar.
Theoretically, this makes crypto the perfect inflation hedge. However, this has not played out in the markets.
Since the reopening of the U.S. economy in March 2021, and the emergence of “transitory” inflation, the value of Bitcoin has plummeted 50%. The sell-off was much worse for other cryptocurrencies.
While Bitcoin has been compared to “digital gold” by the likes of Ray Dalio, this is not yet backed by any evidence. The conventional wisdom that gold is an effective inflation hedge is also suspect. According to data provided by Morningstar, the price of gold has underperformed inflation in two of the last three inflationary periods.
Sectors That Benefit From Higher Inflation
The two magic words for investors are – pricing power.
Companies and sectors that are able to pass on higher costs to the end consumer will be safer investments in an inflationary world.
The commodity sector is the most obvious beneficiary from inflation. Producers of raw materials, industrial metals and energy will be able to fully pass on the price increases to their downstream customers.
2. Big Tech
Big Tech is in a win-win situation. They have already secured dominant market positions and are riding secular, multi-decade trends in digitalisation and cloud adoption.
Companies like Amazon, Microsoft, and Google, are arguably under-pricing their products relative to what their customers would be willing to pay.
This means that in an inflationary world, cost increases can easily be passed onto the end consumer.
And if you ignore regulatory risk – admittedly a huge risk to ignore – one can make the argument that the Big Tech valuations in China and the US are reasonably priced, even as the markets hit all-time highs.
In the long run, industry regulation could end up benefiting Big Tech by entrenching their market positions and creating barriers to entry for disruptive upstarts.
You can even argue breaking up companies like Google and Facebook due to anti-trust legislation will actually unlock more shareholder value. Google’s search business and Facebook’s Instagram will be far more valuable if they were spun-off as separate companies.
3. Consumer staples
Consumer staples are considered defensive stocks for a reason. The demand for their products are price inelastic, meaning that their customers will need their products almost irrespective of the price (think toilet paper and diapers).
F&B stocks with high levels of brand loyalty can also pass on higher costs of ingredients to their customers.
In short, “best-in-class” consumer products will continue to maintain or grow their market share, insulating their company stocks in an inflationary environment.
Investors Should Plan For The Worst, Hope For The Best
The last inflationary period was 30 years ago.
The biggest risk to global markets are the paradigm shifts that most investors today have no experience operating in. As a result, they tend to underreact to new data and underestimate its potential impact on asset prices.
Complacency and inexperience are a lethal combination.
The central tenet of investing is about managing risk as much as return.
When it comes to inflation, it is a far better policy to plan for the worst instead of hoping for the best.