Who's afraid of the Inflation Wolf of Wall Street?
This would of course have important consequences for the equity markets. During the inflationary period in the 1970s, multiples contracted as nominal rates increased, and the relative performance between the haves (businesses that could protect against inflation) and the have nots widened.
Having been in Brazil at the time when peak inflation reached 3,000 percent per year, I have witnessed the misery it brings. Yet I don’t pay much attention to the prophets of inflation doom. It won’t surprise me if by year-end, some of them will cry “deflation wolf”.
Wall Street talking heads are currently recommending that investors pile into cyclical stocks. In some ways, it makes sense: banks make more money lending at higher rates and energy companies do, too, when the price of oil goes higher. In the short term, inflation will be a tailwind for cyclical companies, and for those who believe they can time the market, we agree that the so-called reflationary trade still has life left in it.
However, if you take a long-term view, the reflationary trade is a reflexive reaction, in my opinion. Ultimately, what matters for stock appreciation is real, not nominal earnings growth.
Quality is the silver bullet
In a scenario of high inflation, at a minimum, investors should consider companies that can protect against it. It is even better if you can invest in companies that can actually thrive under inflation, such as those that have one or more of the following characteristics:
- A unique product/service that customers rely on or cannot switch to a cheaper version,
- revenues that are linked to inflation, and
- scale and market leadership to influence prices. Inflation or not, those are the businesses we think investors should focus on.
Generally, investors should beware of long-term investment decisions based on short-term headline news. We understand that it is hard to go against the crowd. Today, inflation is the center of attention, but economic cycles come and go, as do the scaremongers. Shifting tactics to low-quality cyclicals might work for a time, but ultimately stock prices tend to follow earnings and we think a portfolio of quality growth stocks can stack the odds in your favor.
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