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Friday, July 29, 2022
How can investors protect their portfolios in times of inflation?
By Century Financial in Brainy Bull
Inflation is back. Around the world, central banks are struggling to rein in runaway rates, as consumer demand spikes at a time when global supply chains are already plagued by disruptions. After reeling from debt brought on by the Covid-19 pandemic, major economies were thrown into further uncertainty when Russian troops entered Ukraine, exacerbating shortages and sending commodity prices haywire ever since.
In the US, the consumer price index (CPI) — a commonly used measure of inflation — reached a 40-year peak of 7.5% in February. That same month, the UK rate reached its highest in three decades at 6.2%, as many households feel a cost of living squeeze amid soaring energy and food prices.
And it doesn’t appear to be slowing down soon. In May, US inflation accelerated to 8.6% — the highest since 1981 — while UK inflation reached a four-decade high of 9.1%. Heightened recession fears in Germany over a potential halt of Russian oil and gas imports also hiked its rate to a 40-year high of 7.9% in May.
The last time investors had to navigate a high inflationary environment was in 2008, when gas prices reached record highs, and before that it was the Iraqi invasion of Kuwait in 1990. With rapid post-war inflationary episodes not uncommon, investors could take a lesson on inflation from the past.
Economic consequences of conflict
This is by no means the first time that the markets have been under this kind of pressure, points out John Alberg, CIO of Euclidean Technologies. “We are in a volatile market,” he tells Opto, “but it is no more volatile than many other times in the past 60 years.”
The market conditions of early 2022 are somewhat alike to the high inflation seen in the 1970s as a result of the Vietnam War, Richard Sylla, professor emeritus of economics at NYU Stern, says. From 1966 to 1981, US inflation stood at an average of 6% — considerably higher than the 0–3% that is most ideal for equity markets.
In his book, A History of Interest Rates, which tracks inflation and interest rate trends over four millennia, Sylla and his co-author Sidney Homer note the “regular coincidence of interest-rate peaks with wars over several centuries” and identify five “great cycles” of bond yields in US markets. Conflict and inflation, they maintain, usually go hand in hand, with the result that interest rates can “provide a sort of fever chart of the economic and political health” of a nation.
Protection from inflation
There has been a great deal of discussion about the types of asset classes that are more resilient during periods of inflation, particularly as it is expected that this inflationary era may last a long time.
“People have argued that gold, energy and even crypto are such asset classes,” Alberg says. “But if you look at the data going all the way back to the 1930s, value investing has always performed very well relative to growth investing over periods of extended inflation.”
While Alberg agrees that investing in value stocks offers the best returns in inflationary periods, the situation is not always so straightforward as selective growth stocks can also be resilient in uncertain market conditions.
The US investment management firm, which uses deep machine learning to interpret historical trends and identify stocks with long-term potential in times of high inflation, saw returns of 21% in 2021. The fund’s largest holdings include consumer staple Seneca Foods [SENEA] and industrial manufacturer Tredegar Corporation [TG] But Euclidean also increased its stake in semiconductor photomask company Photronics [PLAB] earlier this year, which has seen steady growth over the past few years and recorded 28% growth in revenue year-over-year in the second quarter of 2022. While many other tech stocks have suffered since the start of the year, the Photronics example demonstrates the importance of evaluating each individual company to identify stocks whose growth appears not to be hampered by external headwinds.
“One must view the market’s daily ups and downs as little more than a reflection of the very human, emotional ride across fear, apathy and exuberance,” Alberg says. “By accepting the market for what it is, you can avoid the temptation to become anxious or excited by short-term market moves.”
It takes tremendous discipline to stay put in investments as they erode. As Morningstar’s CIO Dan Kemp told the Opto Sessions podcast in March, staying resilient is the easiest way to outperform the market. “It’s very tempting when markets are volatile to take all your money out and go to cash or do something completely different with it”, he said, but inevitably brash moves lead to losses.
Pricing power stories
James Davolos, portfolio manager at Horizon Kinetics, says that to find the companies likely to remain resilient, investors “need to do the work to identify the long-term winners”.
In Sylla’s view, a long-term winner is likely to have “enough market power to raise its prices and earnings above the rate of inflation”. This is largely dependent on brand loyalty and effective management. Investors, he says, would be wise to consider firms with strong “market power and managerial capabilities”, as these companies will be able to raise their prices without losing business.
In April, Barron’s compiled a list of 27 S&P 500 companies that are likely to outperform during times of inflation due to their “pricing power”. These companies are generally ones that provide an essential or highly sought-after service and have few direct competitors. The line-up notably included Microsoft [MSFT], Merck [MRK], Nvidia [NVDA] and Broadcom [AVGO].
The report highlights that these companies are able to set themselves apart from the competition and are continuously innovating, which could help them to maintain healthy profits even in inflationary conditions as consumers may still find their products desirable.
While Davolos doesn’t have first-hand experience investing in times of inflation, the impact of the last period of true inflation in the 1980s on his family’s business meant that he “view[s] all investments within the context of risk, and how to mitigate these risks in inflation”. This mindset has helped Davolos and his co-managers of the Horizon Inflation Beneficiaries ETF [INFL] (see boxout) to construct a portfolio of equities that stand to benefit from inflationary conditions.
“The highly speculative, leveraged businesses are not attractive long-term investments, and will require an exit strategy as the cycle matures,” Davolos told Opto. “Conversely, the higher-quality businesses are much more likely to compound over this entire inflation cycle.” However, he expects that at some point in the future inflation will shift from capital goods to consumer-oriented goods and services.
Stern warnings of sustained market volatility have been raised from market experts. “Given the state of the world (geopolitically), global economy, central bank conflicts — make no mistake, there will be far higher volatility than we have become accustomed to over the past decade,” Davolos says. However, he points out that “all inflationary cycles are unique and need to be analysed as such”.
“The current disinflationary cycle, which I believe has just ended, lasted about 40 years. Many of the preconditions for that cycle have ended and are even reversing. So, this inflation cycle will be secular, albeit with volatile CPI readings over the course of the next decade or so.”
Other investors, like Alberg, believe it’s too difficult to forecast how long this economic cycle will last. While the current inflationary environment has lasted longer than many experts anticipated, he notes that there is a “behavioural aspect” to inflation, wherein the belief that prices will continue to rise will result in this happening as workers ask for higher wages and companies increase their prices in anticipation of raw material costs going up.
Ultimately, the outlook is still unclear. However, investors can look out for market signals to give an indication of what the future may look like. “The main thing to do is watch the Fed and other central banks, and pay less attention to interest rates than to the amount of money they are creating,” Sylla says.
“I will forecast that stock returns between now and 2030 or 2031 will be low, even if inflation moderates. That’s what 200 years of US stock market history would predict.” However, he points out that “lately there is a good sign that money growth is down to the 5–6% range; that could lead to lower inflation by 2023 or 2024”.
Source: This content has been produced by Opto trading intelligence for Century Financial and was originally published on https://www.cmcmarkets.com/en-gb/opto/how-can-investors-protect-their-portfolios-in-times-of-inflation.
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