A spectre from the past returned to haunt financial markets in late 2016. The election of Donald Trump has awakened fears inflation is ready for a comeback. The assumption is that Trump will slash taxes and boost spending, which will drive the US economy forward at a pace fast enough to ignite inflation in the US and around the world.
In the UK, the inflationary menace has already re-appeared, with November seeing prices rise at their fastest pace in two years. This trend is likely to accelerate in early 2017, as sterling’s slide pushes up the price of imported goods.
Inflation poses the greatest threat to investors in bonds, since these are essentially IOUs issued by governments and companies. These instruments pay a fixed income whose value will be eroded by any upturn in inflation. By contrast, the stock market could provide a haven. Potential profits growth is a key factor in determining the price of a stock and, since companies can in theory simply pass on higher costs to customers, that potential should be protected. Therein lies the paradoxical allure of equities. In the short-run, their price volatility makes them riskier than bonds, but to the long-term investor they have historically outperformed.
A story about consumer goods companies
Equity researchers have studied the market price movements, considered the coming inflation and crafted a story; one in which investors should buy the stocks of banks and industrial companies – both of which tend to benefit from faster economic growth – and shun utilities and suppliers of basic consumer goods. The latter two areas tend to generate steady returns, but won’t benefit particularly from an economic pick up.
The evidence, however, suggests that things are different in the real world. It indicates that investors would be wise to choose basic consumer goods companies. We can illustrate why by looking back to the painful inflationary experience of the 1970s and early 1980s. Inflation ran so high during this period that several companies published extra accounts, adjusted for the impact of inflation on profits. Scanning through the accounts of US companies from this time, it’s clear that the stock price of businesses such as the petroleum giant Exxon and the aluminium business Alcoa were expensive when one takes account of inflation. Moreover, the US financial institution Wells Fargo delivered a wild ride to investors during this period, according to one measure of profit. All of these companies require very high levels of capital.
By contrast, stripping out the impact of inflation reveals that the consumer products business Colgate and the drugs firm Pfizer offered much greater value. Critically, both of the latter businesses require relatively low levels of investment to generate their profits.
Steady Eddies don’t always win the race
This is because company accounts lag inflation. Revenues and profits increase, but their purchasing power when adjusted for inflation declines. This is particularly damaging to companies that must spend heavily on inputs such as equipment and machinery.
In such a world, companies that do not require high levels of investment and generate relatively high levels of profits should fare best. This is particularly true if they are able to pass on higher costs to consumers. They may, for example, sell an essential good with few competitors and/or own a brand that is so strong that few consumers will consider other options.
This perspective is particularly pertinent at the moment as the market reaches a crossroads. The price of government bonds has fallen recently, reflecting the expectation of higher inflation. By contrast, the stock market is focusing on prospects for higher economic growth and the share price of the most economically-sensitive firms has fared dramatically better than `Steady Eddie’ companies.
Strategists claim this trend has further to run. Yet, if there is inflation ahead, history suggests investors are more likely to find relative safety in capital-light industries with pricing power, such as consumer products, software and pharmaceuticals, rather than banks and industrials.