Winners lose out if inflation rises

Global companies such as Tesla and Netflix and the buy now, pay later sector in Australia are all vulnerable to an adjustment in inflation.

German workers taking home bundles of cash, their daily wage due to inflation during depression of 1920s in Germany.

Amid all the fears of inflation, any help in understanding the impact on investment markets is always appreciated. To that end some helpful research has been doing the rounds from global macro research house Gavekal.

By way of background, Gavekal most recently dissected S&P 500 returns during periods of inflation and disinflation (falling inflation) by comparing a Consumer Price Index (CPI) trend, measured over 12 months, to a long-term CPI trend measured over seven years. Putting aside the risk of “curve-fitting”, the idea is to define periods when structural inflation is rising and periods when it is falling.

Periods when the short-term inflation trend is above the long-term trend are defined as periods of inflation, while phases when the short-term trend is below the long-term trend are defined as periods of disinflation.

Curiously, over 142 years since 1878 the US has spent about half the time experiencing inflation and almost the other half in disinflationary periods. Outright deflation between 1929 and 1933 made up the remaining period.

Rather more shocking are the findings from examining the S&P 500’s returns during these periods. Gavekal’s analysis reveals virtually all of the S&P 500’s positive returns since 1978 have been generated during disinflationary periods.

In other words had you only invested in the S&P 500 during the disinflationary periods, your returns were about the same as the index over the entire period. This is startling because it means investors could have dramatically lowered their risk by investing in the safety of cash for almost half the period. And of course there were periods in the last 142 years when interest rates on cash were rather rewarding.

Consequently, the research concludes that inflation is relatively bad for stocks, so one may as well be in cash because cash offers much less risk or volatility.

The research goes further, covering some ground I’ve dealt with before: you might recall stocks most sensitive to changes in interest rates are those with the bulk of their earnings pushed well out on the horizon. Businesses unprofitable today but with hopes of winning slices of large total addressable markets (TAM) are referred to by many as “long duration” or growth stocks and these are the companies that have benefited most as interest rates fell precipitously between 2009 and 2021.

Global companies such as Tesla and Netflix and the buy now, pay later sector in Australia are all vulnerable to an adjustment in inflation.

As rates rise, the present value of a long-dated future dollar of earnings falls precipitously. Long-duration growth stocks are hit the hardest. And because periods of inflation are often accompanied by rising bond rates it is perhaps unsurprising that Gavekal found inflationary periods were harsh on growth stocks. In fact, Gavekal observed PE ratios collapsed in “every inflationary period”.

Therefore, if inflation does indeed emerge in 2021 or 2022, the recent winners could quickly become the losers.

But there’s little consensus on whether a period of inflation or disinflation in the US is around the corner, and nuanced versions of both scenarios seem plausible.

One credible version of events involves a large spike in inflation in coming months as a consequence of a snap back in spending after lockdown, that is then followed by more muted price growth — if any.

Under this scenario inflation proves to be temporary. Rising commodity prices might also reflect speculation, and commodities make up a smaller proportion of finished goods prices than labour costs, which remain in a state of significant excess capacity.

Importantly, software and technology has rendered the marginal cost of many things zero. This too could mean structurally lower levels of inflation or even disinflation for an extended period.

Gavekal also created an inverted inflation/disinflation index (structural inflation), noting it rises and falls in lockstep with PE ratios. It is worth noting that with the exception of the deflationary 1929-33 period, when prices also fell, all of the bear markets in the S&P 500 took place during periods of structural inflation.

So where do you invest knowing the stock market likes disinflation but detests inflation and deflation? (Disinflation refers to a slower rate of inflation, but deflation refers to a fall in prices). According to Gavekal, if inflation emerges and persists, Asian currencies, gold, and inflation-linked bonds are the best places to invest. If inflation jumps but then begins to fall (disinflation) the stockmarket could boom.

But there’s more to the inflation/disinflation picture than meets the eye. Back in 2018 Gavekal broke down the inflation/disinflation picture further.

Instead of simply splicing history into periods of inflation and disinflation, Gavekal created quadrants. Disinflationary booms or periods of rising growth and falling inflation were great times for equity investors, especially growth investors, although bonds also did well. In such an environment, the best risk-adjusted returns often came from portfolios half in long-dated bonds and half in aggressive growth stocks.

Disinflationary busts, or phases of falling growth and falling inflation, were bad times for equity investors and even worse for commodity investors.

 During inflationary boom periods, or times when rising growth was accompanied by inflation, the best place to be was usually value stocks, commodities and emerging markets.

 Finally, during inflationary busts — phases of rising inflation and falling growth — investors were best served by taking in gold, or the cash/currencies of countries running large current account surpluses and/or large fiscal surpluses.

Gavekal’s work suggests you only want to be in shares during disinflationary periods. The 2018 note reveals there are collapses of PEs during periods of disinflation, if the economy is simultaneously going through a bust.

It’s difficult, but one thing that appears to be consistent through the ages is that inflation shrinks PE multiples. And the higher the inflation, the greater the pressure on PEs. Moreover, during periods of inflation, bonds do not provide a cushion for equities. You’re better off building a hedge with cash or gold (bitcoin anyone?).

Roger Montgomery is founder and chief investment officer at Montgomery Investment Management.