- There are three scenarios when it comes to stocks and inflation.
- The only thing you can do is be prepared and avoid risky things.
Last week’s key number to watch was inflation which surprised on the upside – higher inflation should lead to higher interest rates but the FED might let inflation run a bit in order not to hit the brakes too hard. However, the markets didn’t react, everybody was buying the dip as the salespeople—sorry big banks—came out with statements that it’s all fine.
It’s important to know how inflation impacts stocks and then see whether the scholarly model fits this environment.
Technically, inflation increases input costs for companies but also increases their revenue thus stocks should be a hedge against inflation and their profits should rise accordingly. Historically, 99.7% of stock market returns are thanks to inflation and dividends so you can feel a bit protected by owning stocks but what has happened in the past might not be what awaits us in the future.
I wouldn’t get into analyzing historical stock market returns in relation to inflation because it depends on so many factors and academic findings are also divided on it. Common sense is the best way to go now, more about that later.
As you know, the FED and other central banks aim for stability and what they don’t want to see is a spike in inflation because that would make it difficult for companies to transfer higher costs to customers and lower corporate profits, investments, and activities.
Another important factor is the weak dollar which makes U.S. imports and commodities more expensive but aids exports. Nevertheless, the weak dollar increases inflation.
A Common Sense Approach To The Impact Of Inflation On Stocks
So from a broad perspective, inflation isn’t such a threat to stocks but it can lead to other things developing—which is the common sense perspective I mentioned before—while in the short term, higher inflation will benefit some stocks and punish others.
Common sense tells you that higher inflation is bound to have an impact on stocks as the FED is forced to increase interest rates to prevent the economy from overheating, and thus the risks for recession increase. As the risk of a recession increases, so does the risk of lower future earnings which isn’t a good sign for stocks. Plus, you always have to compare stock valuations to bond yields which are rising right now.
Stocks still carry a 4% earnings yield while the two year Treasury is at 2.2%. In the short term, stocks can continue strong but over time there will be lots of risk rebalancing that will increase the gravity for stock prices.
Now, what’s important here is that if inflation continues and the FED continues to raise rates, bond yields will go up and stocks will go down, even if it doesn’t seem like that can happen now. What is the difference if that happens in 2019 or now? Think about it and take advantage of the extremely high market levels to protect your wealth.
Inflation has 3 effects on stocks. It increases revenues and profits, increases yields on bonds, and puts negative pressure on stocks and might be the first indication of an overheating economy followed by a recession. So one positive and two negatives to balance out. By keeping a long-term perspective on what is going on, you can easily make your calls.
Let’s look at which stocks could be punished first.
Stocks that focus on paying dividends typically have established revenue streams and prices that can’t be changed as fast as inflationary pressures. So these stocks usually don’t do well with higher inflation. Further, higher inflation leads to higher interest rates where Treasuries are considered risk-less. A Treasury with 2% or 3% yield might look much more attractive to investors than a stock with the same dividend.
Stocks With Low Returns On Capital & High Debt
With higher inflation, stocks that operate in highly competitive environments with high debt levels accumulated thanks to low interest rates will get hammered.
Be careful not to own such stocks in an environment where higher prices can’t be transferred quickly to the customer. So focus on companies that not only generate earnings, but also generate cash because the companies that have to invest a lot to keep doing business will find higher wages and prices a big burden.
The Stocks That Will Do Well
Stocks that have fixed interest debt with long term maturities and can quickly increase prices without worrying about demand will do well.
Also, value stocks that have lots of assets will do better with higher inflation because the assets give protection. It’s unfortunate that many businesses haven’t focused on creating book value for shareholders but instead on doing expensive buybacks at high price to book values.
Commodities usually do well in the late part of the economic cycle, but now it might be a bit too late for that as most commodities are significantly up in the last two years.