Whilst recessions are costly, they are argued to be the natural balancing act needed to end the misallocation of investment capital when bubbles...
While most investors expect prices to increase as the global economy recovers, concerns about the speed and trajectory of the recent rises persist
Investors continue to try and assess the route of inflation.
While most market participants expect prices to increase as the global economy recovers, concerns about the speed and trajectory of the recent rises persist. In the US, the US Federal Reserve officials continue to downplay rising price pressures as transitory that will quickly fade with post-pandemic normalisation.
Annual Inflation Rate 1989 - Present
US Fed Vice Chair Richard Clarida said the central bank can also take steps to cool a jump in inflation, if it occurs, without derailing the economic rebound coming out of the coronavirus pandemic.
Many commentators believe the US Fed has its head in the sand pointing out that the growth rate of M4 (broad money supply measure) has skyrocketed, growing at 28.9% at the end of 2020, the highest year-end rate since 1943 and today are still elevated at 24%. These rates dramatically exceed a rate that would be consistent with the Fed’s inflation target1.
Deutsche Bank analysts point out that US inflation data surprises are at their highest in 20 years and the last 10 data points were almost off the charts. The consistent data surprises are somewhat inconsistent with the argument that this bout of inflation is transitory2.
Why is inflation so bad for the markets?
When inflation rises, the purchasing value of money declines, and each dollar can buy fewer goods and services. Bond prices tend to fall and stocks become less attractive as it's harder for interest and dividends to keep up with inflation levels. Despite finding it harder to keep up with inflation levels, dividend-growing stocks do offer a hedge against inflation.
The purchasing power of people declines: As wages increase due to inflation, taxation on income increases due to tax bracket creep, leaving people with less money in their pocket to pay for more expensive goods. This phenomenon amplifies the negative effects on consumers and investors, who now have less money to invest
Inflation can be self-perpetuating as it may cause future inflation expectations to rise. For example, an increase in inflation causes people to demand higher wages which itself translates to higher inflation.
Central banks tend (ordinarily) to use monetary policy to cool inflation, by raising the cost of borrowing. This can also have a negative effect on bond and stock prices, in particular growth stocks whose cashflows need to be discounted from way into the future.
The Great Inflation in the 1970s.
The worst stock performance of the 1970s came not when inflation peaked but when it first spiked rapidly. From 1972 to 1973, inflation doubled to more than 6 percent. By 1974 it was 11 percent. In those two years, the S&P 500 declined by a combined 40 percent. Inflation was higher in 1979 and 1980, topping out at 13.5 percent, by which time the S&P 500 had long returned to positive performance, though on an inflation-adjusted base. It was a lost decade for stocks3.
Investing during Inflationary Periods
In the late 1970s and early 1980s, Warren Buffet devoted significant portions of the Berkshire Hathaway annual letter to investing in stocks during inflationary periods3.
“Unfortunately, earnings reported in corporate financial statements are no longer the dominant variable that determines whether there are any real earnings for you, the owner. For only gains in purchasing power represent real earnings on investment. If you (a) forego 10 hamburgers to purchase an investment; (b) receive dividends which, after tax, buy two hamburgers; and (c) receive, upon sale of your holdings, after-tax proceeds that will buy eight hamburgers, then (d) you have had no real income from your investment, no matter how much it appreciated in dollars. You may feel richer, but you won’t eat richer.”
“High rates of inflation create a tax on capital that makes much corporate investment unwise - at least if measured by the criterion of a positive real investment return to owners.”
Warren’s advice is to look for companies that are generating cash, can increase prices inelastically and handle a lot more business without having to incur a lot of capital expenditure. This is probably great advice irrespective of the inflationary cycle.
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