Inflation. It’s all you hear nowadays. Inflation, Inflation, Inflation. The fear we hear from the word inflation when it is uttered on Bloomberg or CNBC is reminiscent of the name Baba Yaga in the movie John Wick. But why does the market fear inflation as much as the Russian mobsters who feared a widowed hitman seeking vengeance for his murdered dog?
Let’s start with the basics: what is inflation? Put simply, it’s the rise of prices over time. If demand for goods increases more quickly than supply, prices will rise, which results in inflation. It is the rate of change in the prices for everything from a car to a pint at the local brewhouse (Chanhassen Brewing, in my case).
The anticipation of inflation often intensifies the process because consumers will be inclined to make purchases sooner rather than later if they fear that goods or services will cost more in the future. The increased buying results in shortages of supply, which inflates prices even faster.
Except for education and healthcare, inflation has been remarkably low for well over a decade. But it hasn’t always been that way; in the 70s to early 80s, inflation caused some bad memories for baby boomers. In 1979, inflation exceeded 11%.
From the perspective of an average person, as long as wages go up at the same rate as the goods and services, there is not much to worry about. Their standard of living does not change. Their dollars may buy less, but their annual wage increases make up the difference.
Unfortunately, sometimes our wages do not keep up with increasing prices. As an extreme example, a teenage basketball player in Venezuela may see a pair of sneakers on Monday for Bs100 (their $s), but on Friday, they may cost Bs200. The Bs100 that he had in his pocket to buy the pair of shoes is now worth less. And if you have a teenage son as I do, you know how important basketball shoes are!
Why does the stock market care so much about inflation? Just like for the average consumer, as inflation rates rise, the value of a company’s future earnings decreases.
This is caused by something called the discount rate. If you are buying something in the future, how much you are willing to pay for it now depends on inflation and interest rates. One helpful example is to think about a savings account. If a savings account is yielding 0.5% and you want $100 in ten years, you would put in roughly $95 in it today. Because rates are so low, the future value of the $100 is worth about the same today as it will be in the future.
If the interest rate on a savings account jumps up to 3%, you only have to put in less than $75 to get to the $100 in the future. That future $100 is worth much less today than in 10 years due to higher rates.
If inflation is 0%, a $100 today is the same as $100 ten years in the future. If inflation is 3%, $75 today is the same as $100 ten years in the future. Or, with 3% inflation, $100 today is the same as $135 in the future. You can inflate into the future or discount into the past.
The impact of the discount rate is especially impactful for growth stocks, like technology companies, whose price is based on future growth and future cashflows. Their current price is high compared to their current earnings because of their future growth potential, and as a result, it takes you longer to reap the rewards. If the stock price is $30 and the company has $1 of earnings, it will take 30 years to get your investment back. And if inflation is increasing, the buying power of those future cashflows is less.
Value stocks, like energy and financials, are priced lower because they aren’t growing quickly. If a company has a stock price of $5 and earnings of $1, you get your $5 back sooner. The future growth prospects might not be as good for this type of company in 5-10 years, but it may be a more attractive option in an inflationary environment. You throw in the fact that value stocks usually pay larger dividends; this is even more attractive in an inflationary environment. You get even more of your money back sooner before inflation can increase even more.
Growth stocks are sometimes considered long-duration assets, like bonds. As interest rates and inflation go up, their value goes down because the payoff is in the long into the future. One of the reasons growth stocks have outperformed value stocks over the last 10+ years is that we have been in a low-inflationary environment. To bottom line it, a stock’s price is the risk-adjusted price of future cash flows.
The curious thing about the market and inflation is that over the long term, there are few investments that have a better history of giving you a return above inflation than stocks. After all, many companies actually have the ability to raise their prices to compensate for inflation. Not all companies have pricing power, but many do. Their earnings won’t suffer if their labor and goods costs increase; they simply pass it along to the consumer.
What the market is probably fearing now is that if there is too much inflation too quickly, it could actually cause a slowdown in the economy. And while it seems like a contradiction, it goes something like this: as inflation and interest rates rise, workers will demand higher wages so that they can maintain their standard of living.
For instance, our basketball player in Venezuela is going to demand a higher salary to buy the shoes – understandably so! But if the demand for wages is too abrupt, companies won’t be able to afford higher wage increases for the same number of employees, resulting in workforce reductions. Unemployment could actually increase at the same time as inflation.
This is where an even more dreaded word comes from; stagflation — think the 1970s. Some might say that is even worse than getting on the bad side of John Wick. (Although can you blame him? They did kill his dog!)
As you might guess, moderate inflation can be a good thing. We want economies to grow and for wages to increase. We want our standard of living to go up. It is the threat of runaway inflation that is rattling the markets. It is also the unknown — markets hate uncertainty.
Even if you don’t fear inflation, you should prepare your portfolio and financial plan for it. Financial plans are especially vulnerable to inflation. Our next blog will give you tips for protecting your portfolio and financial plan from the effects of inflation.
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