The Inflation Effect on Investing
Inflation has broad and profound effects on the economy, particularly in the worlds of business and investing. It puts added pressure on businesses to control their costs, and often requires that they increase prices for their customers. This is an uncomfortable position to be in, as this substantially changes the predictability of once-routine operations, and can make year-to-year profitability somewhat more volatile.
For investors, the effect is two-fold. First, if they are invested in businesses, they are exposed to the same conundrum as business operators. The other impact felt by investors is greater uncertainty around what their investments are worth. This is because inflation influences the rate of return they need from their investments; if inflation is running at 5%, and your investments are only returning 4% a year, you are losing ground in relative terms.
As a result, when inflation comes in higher than expected, this translates into lower justifiable valuations, which can cause market declines as valuations contract.
Private investments feel the same pressure, even if much of the underlying volatility is masked by infrequent (or nonexistent) mark-to-market events. What is more dangerous here, compared with publicly traded investments, is that exit-multiples may be unknown for much of the investment period, creating a mismatch between where investors think they are financially, and what they actually have available. This is a financial planning nightmare.
Over the last few months, many publicly traded companies with the loftiest valuations have seen their share prices cut in half (or more). In the private markets, venture capital investments, even if they do not see declines on paper, will likely see a few years of low or zero returns. Hence the financial adage: risk cannot be eliminated, it can only be transformed.
Meanwhile, some companies have actually thrived in the face of inflation. While nearly all valuations have declined (relative to economic fundamentals), some companies have seen their profits explode to the upside, causing their overall share price to increase. Many of these are companies with large amounts of fixed rate debt, underutilized fixed assets, and commodity products.
First, inflation erodes the value of the debt they owe (in real terms), while increasing the prices they can charge for their products. This hugely improves their financial health. They now have more profits and more shareholder equity relative to their debt load.
Second, inflation is basically the outcome of too many dollars chasing too few goods and services. For businesses with extra capacity, this leads to a huge boost in revenue without increasing costs. Operating profits boom as a result.
Third, beyond the operating leverage enjoyed by these businesses, you see a further increase in their margins as they raise prices for the goods they provide. For a business producing an undifferentiated, commodity product, this is a rare event and leads to supernormal profits.
To summarize, inflation has most negatively impacted high-growth, high-valuation companies, while benefitting relatively cheap but undifferentiated, slow-growth businesses.
But then, you still have all the companies in the middle of those extremes. What about those average businesses with healthy valuations, moderate growth, and moderate pricing power? That's a more complicated subject, even though it applies to the vast majority of the S&P500's constituents (by market cap, anyway). For a more in-depth discussion, I encourage you to check out the video below, as well as my notes accompanying it below.
Data Update 3 for 2022: The Inflation Effect on Investing. By Aswath Damodaran.
Original video here: https://www.youtube.com/watch?v=lMEyjqXBU4U&t=560s
How our understanding of inflation has evolved over the course of 2021, and what lies in store for 2022, with expectations moving from "transitory" to "who knows?"
The different ways of measuring inflation, CPI, PPI, and GDP deflated, which are mostly similar. Note, however, the volatility of PPI relative to CPI. This is because prices for consumers tend to be more stable (likely a result of steadier, more predictable demand), where as the economic situation of producers tends to be more volatile as you move further away from the consumer, and closer to the commodity inputs. All three inputs point to the fact that inflation is currently happening.
Elevated PPI may be due to supply chains, but even at the consumer and economy-wide level, you see elevated inflation figures.
The rate of inflation implied by the spread between the TIPS v 10-year T-bond market is 2.51% for the next 10 years.
Investor expectations have gone from 7% of investors expecting inflation to exceed 2.5%, to 94%.
The benign view is that as supply chain issues resolve and the economy normalizes, inflation will revert to lower levels
The threat is that unsustainable fiscal stimulus continues dumping dollars into a system that is already running at full capacity. In a weak economy, fiscal stimulus helps take up some of the slack. But with an economy running hot, there is no slack and all that results is increasingly aggressive bidding wars for productive capacity.
For corporate bonds, default spreads decreased most for high yield bonds vs investment grade bonds. This indicates an increase in the availability of return-seeking "risk capital."
Damodaran believes the Federal Reserve is not solely responsible for interest rates, and is merely an "influencer" of rates. This makes sense because while they are the largest marginal participant in bond markets, they are not the only participant, and if the private economy develops a substantially different view of interest rates from what the fed puts forward, the fed's influence may not be sufficient to obtain its desired outcomes.
Drivers of interest rates in the long term can be explained by changes in the real risk free rate (the inflation-adjusted minimum rate of return required by investors). The risk free rate is composed of expectations for real GDP growth, combined with the expected inflation rate.
The past decade of low rates can be explained fully by low inflation and low GDP growth, even without accounting for the Fed.
What's opening up now is that the T-bond rate is diverging from the real risk free rate. Historically, this divergence has almost always closed. Either the T-Bond rate increases to match the risk free rate, or the economy can go into recession as GDP growth and inflation decrease to match the T-bond rate. From an asset owner's perspective, it isn't obvious which one is better. Higher rates hurt asset values. But recessions also hurt asset values. (Nicholas note: The only asset not impacted by either of these scenarios is cash.)
Expected inflation vs unexpected inflation. Expected inflation can be factored into decisions made by investors and business owners. The economy can adjust and deal with it in standard, predictable ways. Unexpected inflation is the more dangerous of the two. It causes problems for day-to-day business operations, and creates the biggest potential for losses by investors.
The bear market of the 1970s happened in a period where unexpected inflation came in consistently above expectations. Meanwhile, the secular bull market of the 80s and 90s, saw mostly lower-than-expected inflation.
Grouping returns by year, you see better inflation-adjusted performance for stocks when inflation came in lower than expected, and worse inflation-adjusted performance when inflation came in higher than expected. You might think bonds offered safe harbor during these periods, but in fact the effect is even more pronounced for bonds than it is for stocks. Bonds did worse during periods where inflation was higher than expected, but better during periods where inflation was lower than expected. This is not the moderation most contemporary investors expect from bonds.
What stocks do better when inflation is higher than expected? Small market-capitalization stocks, and cheap stocks. In other words, "Small Cap Value."
Large cap stocks and growth stocks, meanwhile, tend to do better when inflation is lower than expected. The last decade saw massive outperformance by large cap growth companies relative to small cap value stocks. In fact, this outperformance was so strong that it wiped out much of the historic outperformance of the small cap value factor, to a point where statisticians declared that the small cap value premium no longer exists. The next decade may tell a different story.
But what about non-financial assets? Damodaran includes data for gold and real estate. Real returns for real estate have low correlations with inflation surprises in either direction. Higher-than-expected inflation benefits real estate in nominal terms, but only to the extent of inflation, you don't come out very far ahead, but neither do you lag so significantly when inflation is lower than expected. It's a balanced asset class, which is why most real estate investors love it. Gold, meanwhile, tends to perform well in periods of higher than expected inflation. It's actually a decent diversifier for a surprise-inflation environment.
Inflation may be different for two different currencies. You can have high inflation in one currency, and low inflation in another. This is reflected in interest rates for these countries, which tend to be higher in countries with higher inflation. But there's another wrinkle to this analysis, which is that not all government issued debt has zero default risk. Many countries have defaulted on their debt, so investing in foreign sovereign debt, is not a risk-free choice. This is true even when issued in local currency (meaning the government can just print however much they need to pay off the debt, and they don't always do this).
Differences in inflation rates between currencies predict expected equilibrium exchange rates in the future. Globally high inflation doesn't have much impact on exchange rates. If, however, some countries experience high inflation vs others, you'd expect their currency depreciate over time.
Cryptocurrencies and NFTs are either currencies or collectibles, and should be analyzed accordingly. What data exists, though, suggests that cryptocurrencies and NFTs behave like high-risk financial assets, which means they offer little to no diversification benefit to a traditional portfolio of stocks and bonds (crypto goes down more than stocks in a bear market, and up more than stocks in a bull market, at least so far).