Inflation over the long-term is a probability but not a certainty. Macroeconomics is a voodoo science; it appropriately belongs in the liberal arts department. The economy is an incredibly complex and unpredictable system.
Here is an example: Japan is the most indebted developed nation in the word (its debt-to-GDP exceeds 260%, while that of the U.S. is 130% or so). Japan’s population is shrinking, and thus its level of indebtedness per capita is going up at a much faster rate than the absolute level of debt. Yet Japanese interest rates are lower than the U.S. and the country has been mired in a deflationary environment for decades.
Admittedly, Japan has many unique economic and cultural issues. Companies are primarily run for the benefit of employees, not shareholders. (Unproductive employees are never let go and there are a lot of “zombie” companies that should have been allowed to fail.) Japan’s asset bubble burst in 1991 when debt-to-GDP was only 60%. The point still stands: long-term forecasting of inflation and deflation is an incredibly difficult and humbling exercise.
As investors we have to think not in binary terms but in probabilities. The acceleration of U.S. debt issuance and Washington’s seeming indifference to both debt and to ballooning budget deficits raise the probability and the likely severity of inflation. At the same time, we have to accept the possibility that the economic gods are playing cruel games with us gullible humans and have deflation in store for the U.S. instead.
Inflation and higher interest rates are joined at the hip. Expectations of higher inflation raise interest rates, as bond investors demand a higher return. This in turn will result in larger budget deficits and more money printing, leading to more borrowing and even higher interest rates.
Here is how my investment firm is positioning our portfolio for the risk — the possibility, not the certainty — of long-term inflation:
Valuation matters more than ever. Higher interest rates are an inconvenience to short-duration assets whose cash flows are near the present, but they’re devastating to long-duration assets. Here is a simple example: When interest rates rise 1%, the value of a bond with a maturity of three years will decline about 2.5%, while one with a maturity of 30 years will slide about 25%.
The same applies to companies whose cash flows lie far into the future and which are thus highly sensitive to increases in the discount rate (interest rates and inflation). Until recently these companies have disproportionally benefited from low interest rates. They are the ones that you will most likely find trading in bubble territory today. But with rising rates their high valuations (high price-to-earnings ratio) will revert downward. Value stocks will be back in vogue again, and investors have started seeing a stock-market rotation from growth to value.
Inflation will benefit some companies, be indifferent to others, and hurt the rest. To understand what separates winners from losers, we need to understand the physics of how inflation flows through a company’s income statement and balance sheet.
Let’s start with revenue. Higher prices across the economy are a main feature of inflation. We want to own companies that have pricing power. Pricing power is the ability to raise prices without suffering a decline in revenue that comes from customers’ inability to afford higher prices or from the loss of customers to competitors.
Companies that have strong brands, monopolies or products that represent a small portion of customer budgets usually have pricing power. For example, if Apple raises prices on the iPhone, you’ll pay the higher price. If Apple raises iPhone prices too much and its products become unaffordable, consumers might think twice about that upgrade.
Tobacco companies also have pricing power. I lived through a hyperinflation in Russia in the late 1980s and early 1990s, I was a smoker then. One day cigarette prices doubled. I experienced a price shock. I cursed at tobacco companies; cigarettes did not get any cheaper. A day later I was paying double again for my cigarettes. Smokers are loyal to their brands, and cigarettes are addictive. My firm owns these stocks, too. The same applies to beer and hard liquor.
The rate of change of inflation matters even more than absolute rate of inflation. If inflation remains predictable, even at a higher level, then businesses will plan for and price it into their products. If the rate of growth is highly variable, then there is going to be a war of pricing powers for shrinking purchasing ability of the end customer. We want to invest in companies that are on the winning side of that war.
Now for the expense side of the income statement. Companies whose expenses are impacted the least by rising prices do well, too. Generally, companies with larger fixed costs do better.
But it is important to differentiate whether the capital intensity of a business lies in the past or in the future. A business whose high capital-intensity is in the past benefits from inflation.
Think of a pipeline company, for instance (we also have stakes in plenty of those). Most of its costs are fixed, and they have been incurred in yesterday’s pre-inflation dollars. The cost of maintaining pipelines will go up, but in relation to the total cost of constructing pipelines these costs are small. However, companies that operate pipelines have debt-heavy balance sheets, which can become a source of higher costs. Pipeline companies in our portfolio, for instance, have debt maturities that go out many decades into the future. They’ll be paying off these debts with inflated cash flows.
I’ve seen studies that looked at asset prices over the last few decades and declared: “These assets have done the best in past inflations.” But most of these studies missed a small but incredibly important detail: The price you pay for the asset matters. If we are entering into an inflationary environment, it is happening when asset prices are at the highest valuation in over a century. (This was not always the case during the period covered by these studies.)
For instance, one study showed that REITs have done well during past inflationary periods. This may not be the case going forward. Aside from this being a broad and general conclusion (not all REITs are created equal), low interest rates brought a lot of capital into this space and inflated valuations. Investors were attracted to current income, which was better than from bonds, and they paid little attention to the valuations of the underlying assets.
I cannot stress this point enough: Whatever landscape is ahead of us, we are entering into it with extremely high valuations and a U.S. economy addicted to low interest rates. So we have to be very careful about relying on generalized comments about past inflations. We need to be nuanced in our thinking.
Gold and cash
What about gold and cash? We don’t have a great love for gold. We have a position through options as a hedge. As for cash, I am basically referring to short-term bonds, which seem like the most comfortable asset to be in today. However, their ability to keep up with inflation has been spotty. Holding cash is O.K. in the short term but likely to be value-destructive in the long term. Our view on cash has not changed: In a portfolio context cash should be a residual on other investment decisions. In our portfolios cash is what is left when we run out of investment ideas.
Investing outside of the U.S.
The U.S. was not the only country borrowing and paying people to stay at home during the worst of the pandemic. But the U.S. has done this to a much greater degree than others. Most importantly, the U.S. is not slowing its spending (and thus borrowing), which will likely lead to a weaker U.S. dollar. If nothing else, a declining dollar makes foreign securities more valuable in U.S. dollars. The probability of a stronger dollar is low.
But there is more. The next decade will likely belong to investments outside of the U.S. If you’d done that over the past decade, your returns were overshadowed by the gigantic outperformance of the U.S. markets. But now the U.S. is the most expensive developed market. Take Europe, for instance; most European stocks are still trading below 2007 highs. U.K. stocks, for example, trade at a half of the valuation of U.S. stocks.
Our approach to investing is simple: We are diehard value investors looking for high-quality companies that are significantly undervalued and run by great management no matter where in the world they operate. Now about a third of my firm’s portfolio is in international stocks.
Moreover, as steward of our clients’ capital, our most important objective is survival — avoiding the permanent loss of capital and maintaining purchasing power — in inflationary (and deflationary) environments.
Vitaliy Katsenelson is CEO and chief investment officer of Investment Management Associates.