If you invest 100 in a value business with a price/earnings (P/E) ratio of 5x, for example, that multiple means your shares should produce 20 each year in profits, and thus you will’recover’ your investment after five years. A growth company, on the other hand, is likely to have a high P/E ratio, implying low earnings now, but growth investors are willing to pay up in the hopes of generating money in years 16 to 20, rather than the first five.
That makes the value business a’short-duration’ asset and the growth business a ‘long-duration’ asset in financial terms. Regardless of the fancy verbiage, the crucial practical lesson is that money now is worth more than money in the future in an inflationary climate. The more money is invested in the future, the less it is worth. As a result, in an inflationary environment, value, which sees investors repay their money sooner rather than later, is more appealing.
Investors, on the other hand, have been significantly less anxious about inflation than deflation during the last seven years or so. Prices of goods and services typically rise with time (that is, they inflate), thus 1 buys you less and less as you look further into the future.
Deflation, on the other hand, causes prices of goods and services to fall, so your 1 will buy you progressively more things or services the further out you look. In a deflationary economy, growth firms, or those with a long-term solid franchise, are valued much higher than value enterprises.
This is why growth companies, particularly high-quality companies with pricing power so-called ‘bond proxies,’ such as food, beverage, and cigarette companies have performed so well recently. It’s also why, if you feel inflation is on its way back and we don’t have an opinion on that, either way it would reverse a big chunk of value’s recent underperformance.
What is inflation beneficial to value stocks?
Consumers, stocks, and the economy may all suffer as a result of rising inflation. When inflation is high, value stocks perform better, and when inflation is low, growth stocks perform better. When inflation is high, stocks become more volatile.
Do value stocks fare well in an inflationary environment?
It seems strange to be concerned about inflation during one of the sharpest and most severe economic downturns in our lifetimes.
However, given the Federal Reserve’s massive government spending and monetary policy, it’s something that many are thinking about as a potential risk in the not-too-distant future. The “concern” is that once the virus has been contained, the economy could overheat as a result of pent-up demand and government spending.
My initial take on this is that if we do get inflation as a result of all of this spending, it’s a good thing since it implies we’ve beaten the virus and are back to business as usual (if there is such a thing).
I’m not taking a victory lap here because I certainly didn’t expect inflation to reach nearly 8%. I hadn’t anticipated so many supply chain challenges as a result of high consumer demand.
And that piece wasn’t so much about making a macro call as it was about figuring out why value equities had fallen so far behind growth stocks in the years preceding up to the epidemic.
My conclusion was that more inflation was required for value stocks to outperform once more. Here’s how it looks:
Value has tended to do better during decades with above-average inflation and worse during decades with lower inflation, however this is not a perfect link. This was my original theory for why this happened:
Consider growth stocks in the same way that you would a bond. The purchasing value of your fixed rate income payments is reduced over time by inflation, which is why inflation is such a huge risk for bondholders.
The same can be said for growth stocks’ predicted future revenue or profit growth. Value stocks are likely to have cash flows that are already decreasing and will continue to do so in the future. As a result, higher interest rates should affect value equities less than growth companies, because the higher hurdle rate reduces the value of future growth.
Let’s put this notion to the test now that inflation has been rising for almost a year.
Since the beginning of 2021 through Monday’s closing, the DFA small and large cap value funds1 have outperformed the market and growth stocks:
During this inflationary period, value equities have excelled by a wide margin. So far, everything has gone well.
When inflation is greater, value tends to outperform for international companies as well:
It would be naive to believe that inflation is the only driver driving value or growth equities. Inflation has a part, but nominal growth is typically higher when inflation is high.
And sometimes value outperforms growth because growth values are too far off the mark.
Because I can’t forecast the future path of inflation (and I’m not sure anyone else can either), I’m not smart enough to predict whether value stocks will continue to thrive.
However, this serves as an excellent reminder of the significance of diversifying your portfolio across economic cycles.
Since reading Ray Dalio’s The All Weather Story a few years ago, this chart from the book has stayed with me:
Because we don’t know when or why the economic environment will change, the aim is to combine investments that work under different economic regimes together.
No one predicted a major inflation/economic growth increase in 2019, yet that’s exactly what we’re experiencing right now.
In a long time, we haven’t had to deal with a rising inflation/increasing growth economy.
Value stocks have been behind for some time, but perhaps they just needed the ideal circumstances to shine.
I’m not predicting that value investment will continue to outperform. I honestly have no idea.
I’m not sure how much of the inflation story has already been priced into value and growth equities.
I’m not sure if the Fed will be able to keep inflation under control.
I am aware that building a long-term portfolio necessitates diversity of techniques that may thrive in a variety of market and economic conditions.
1Full disclosure: DFA funds are used in several of my firm’s client portfolios, and I own some of these funds.
Why are growth stocks affected by inflation?
Inflationary pressures, on the other hand, might be problematic for growth stocks. Because higher interest rates and bond yields are expected as a result of inflation, growth stocks’ promised future cash flows become less appealing.
What investments do well in the face of inflation?
- In the past, tangible assets such as real estate and commodities were seen to be inflation hedges.
- Certain sector stocks, inflation-indexed bonds, and securitized debt are examples of specialty securities that can keep a portfolio’s buying power.
- Direct and indirect investments in inflation-sensitive investments are available in a variety of ways.
How do you protect yourself from inflation?
If rising inflation persists, it will almost certainly lead to higher interest rates, therefore investors should think about how to effectively position their portfolios if this happens. Despite enormous budget deficits and cheap interest rates, the economy spent much of the 2010s without high sustained inflation.
If you expect inflation to continue, it may be a good time to borrow, as long as you can avoid being directly exposed to it. What is the explanation for this? You’re effectively repaying your loan with cheaper dollars in the future if you borrow at a fixed interest rate. It gets even better if you use certain types of debt to invest in assets like real estate that are anticipated to appreciate over time.
Here are some of the best inflation hedges you may use to reduce the impact of inflation.
TIPS
TIPS, or Treasury inflation-protected securities, are a good strategy to preserve your government bond investment if inflation is expected to accelerate. TIPS are U.S. government bonds that are indexed to inflation, which means that if inflation rises (or falls), so will the effective interest rate paid on them.
TIPS bonds are issued in maturities of 5, 10, and 30 years and pay interest every six months. They’re considered one of the safest investments in the world because they’re backed by the US federal government (just like other government debt).
Floating-rate bonds
Bonds typically have a fixed payment for the duration of the bond, making them vulnerable to inflation on the broad side. A floating rate bond, on the other hand, can help to reduce this effect by increasing the dividend in response to increases in interest rates induced by rising inflation.
ETFs or mutual funds, which often possess a diverse range of such bonds, are one way to purchase them. You’ll gain some diversity in addition to inflation protection, which means your portfolio may benefit from lower risk.
How can I plan for inflation in 2022?
With the consumer price index rising at a rate not seen in over 40 years in 2021, the investing challenge for 2022 is generating meaningful profits in the face of very high inflation. Real estate, commodities, and consumer cyclical equities are all traditional inflation-resistant assets. Others, like as tourism, semiconductors, and infrastructure-related investments, may do well during this inflationary cycle as a result of the pandemic’s special circumstances. Cash, bonds, and growth stocks, on the other hand, look to be less appealing in today’s market.
Do you want to learn more about diversifying your investing portfolio? Contact a financial advisor right away.
Is inflation beneficial to technology stocks?
High-growth equities have struggled throughout 2021 and this amazing start to 2022, owing to fears that the Fed may raise interest rates to battle inflation, putting pressure on their valuations. Professor Vittorio de Pedys criticizes all three pillars of the mainstream argument in this contribution based on his impact paper.
The Fed is unquestionably behind the curve when it comes to dealing with inflation. The M2 money supply indicator, which increased by 40% from 2019 to 2021, is a clear indicator of price pressure. Today’s supply chain bottlenecks are the outcome of economic limitations being countered with a significant shift in demand for products vs services, rather than a global economy unraveling. Companies are addressing this issue by re-engineering their supply chains and constructing factories (see Intel, Taiwan semiconductors). The IHS Markit PMI indices in emerging markets have all recently increased considerably, indicating that manufacturing capacity is improving. Money’s velocity is decreasing: because to productivity-enhancing technology, businesses are spending money less fast. Prices will continue to fall as a result of this secular trend. Finally, comparisons will be easier: inflation will be recorded in the second quarter of 2022 versus the substantially higher numbers witnessed throughout 2021. In 2022, tougher comps will inevitably hold down headline inflation. Market data backs up this assertion: the 5×5 years forward-forward in Libor/inflation swaps, a leading indication of market expectations, indicates that market dealers estimate inflation to be 2.5 percent in five years.
Fed funds rates will aim 2.5 percent in 2024 under the most extreme scenario. It’s hardly a frightening figure. Given the high quantity of business and student debt and its low quality, if the Fed hikes rates above the inflation peak, it risks halting the economic growth and unleashing a cascade of bankruptcies, resulting in an economic crisis. The cost of government debt servicing might soar, pushing out other, more vital public spending. On the other hand, if the Fed decides to maintain its current policy, its dovish posture will further fuel inflationary expectations. As a result, the inflate or die trap appears to be the best option. A strong US dollar will also assist in the long run. Because the real rate is minus 5.5 percent, the government can sit back and watch its mountain of debt (now at 136 percent of GDP) shrink. When looking at Fed Funds Future deliveries for the end of 2022 on the CBOT, the market is pricing a 0.874 percent O/N rate one year from now with three rate hikes. A similar message can be found in the EuroDollar Futures, with the expected 3-months rate for June 2024 trading at an unimpressive 1.37 percent. Chairman Jerome Powell is no Paul Volcker, so the Fed will put on a hawkish mask to gain time, then back down as inflation starts to fall in the second half of 2022.
According to Vittorio de Pedys, 2022 will be a stronger year than 2021 since rate hikes are beneficial to hypergrowth stocks. It’s the “roaring technological twenties”!
Since their all-time high in March 2021, high-growth technology stocks have been steadily declining. According to this logic, the higher the interest rate, the higher the discount rate employed in valuation models such as DCF and CAPM, and the lower the value of a growth stock. Higher inflation, on the other hand, has not historically sunk markets. Rates that are higher do. To destroy growth stocks, substantially higher rates than those proposed by the Fed will be required. Even if most people are unhappy, the economy is essentially in good shape. SPACs, Reddit investors, “meme” stocks, cryptocurrencies, and IPOs are all showing signs of froth. In terms of rates, the “danger” zone begins at 5%. According to studies, there has never been a recession with a rate of less than 4%. Over any 19-year period, US stocks have outpaced inflation 100% of the time, according to Goldman Sachs. The market is telling us that the Fed raised rates eight times between 2016 and 2018, and that growth companies prospered throughout that time: just look at Cathie Wood’s flagship ARK Innovation ETF (ARKK), which soared 90 percent during that time. Growth stocks are damaged by the worry of rising interest rates: the pain is limited to the prospect of higher rates. Once this occurs, these equities benefit because their greater growth potential is accurately valued above a minor multiple compression due to somewhat higher discount rates. The adoption of technology by a larger number of people is unstoppable. Hypergrowth stocks are at the heart of these factors, and they will gain from a strengthening economy.