Inflation: what does it mean for my investment portfolio?

If you turn on the finance news or open any financial paper today, the word “inflation” is everywhere. After three decades of hibernation, it would appear the inflation genie might be out of the bottle.

While there are a multitude of causes — underinvestment in fossil fuels, supply disruptions due to COVID-19, border closures impacting employment, fiscal stimulus driving consumer demand, etc — the key question investors must ask themselves is this: "What does it mean for me and my portfolio?"

The challenge with predicting inflation

The challenge with predicting inflation is that the world is complex. It's not like physics or chemistry, which are subject to immutable laws.

Economies are often referred to as complex adaptive systems. Such systems are more than the sum of the parts. They can’t be reduced to simple inputs because everything affects everything else through a complex web of interactions.

Complex adaptive systems are also subject to non-linear outcomes, meaning small chance events can have huge impacts on end results. It's little wonder the track record of economist predictions aren't great.

Berkshire Hathaway vice-chairman Charlie Munger explains it this way: “A great philosopher said,  'A man never steps into the same river twice — the man is different, and so is the river when he goes in the second time.' That's the trouble with economics. It's not like physics. The same damn recipe done a different time gets a different result.”

Are we experiencing déjà vu?

A relevant example comes from Arthur Herman's book Freedom's Forge, about American business and World War II. (1) At the conclusion of the war the world's top economists expected rampant inflation and a recession or depression in the US.

Ten million American soldiers would be returning to empty factories as war manufacturing had grown to about 50% of GDP. US debt to GDP sat at record levels, and price caps implemented during the war were about to be abolished.

In actuality, there were three jobs available for every returning veteran, US stock prices surged, and for the next two decades US GNP grew at 4% each year — the highest economic growth seen in human history.

Why?

US wages had risen 70% during the war, driving what Herman describes as "a tremendous aggregation of purchasing power and tremendous demand for goods". Private capital investment tripled from 1945 to 1946 and never looked back. The economists were wrong; America adapted, and although inflation initially spiked, it then eased.

While our sample size here is only one, could we be experiencing déjà vu?

Lessons from history

No one can predict whether the recent elevated levels of inflation will be more permanent, but the good news for investors is the world has experienced inflation before — and there are some learnings we can take from history.

1. Inflation has not eroded long-term returns

For starters, inflation hasn't ruined investment returns over the long term.

Despite inflation and a multitude of other less than desirable economic and geopolitical events — world war/pandemic/recessions/financial crises/stock market bubbles — the Australian stock market has compounded at about 10% a year over the last 100 years.(2) That's well above the average annual inflation rate.

In owning equities, you’ve been more than compensated for the risk of inflation.

At 97 years young, Charlie Munger has seen plenty. He has wisely noted, "I remember the $0.05 hamburger and a $0.40 per-hour minimum wage, so I've seen a tremendous amount of inflation in my lifetime. Did it ruin the investment climate? I think not.”

2. Inflation has a greater impact on fixed-rate investments

Inflation tends to have the greatest impact on fixed-rate investments, particularly when the yields on offer are low.

When inflation emerges or is anticipated, investors demand higher returns to compensate for their loss of purchasing power, driving bond yields higher and the respective bond prices lower.

As government bond yields rise, investors demand higher returns for more risky assets like equities and corporate debt.

While this may eventuate, the buffer between the yield on government bonds and the earnings yield on the S&P500 is near record highs. This suggests that even if bond yields do rise due to inflation, it doesn’t necessarily mean stock prices must fall.

The long-term chart below highlights the current relationship between the S&P500 earnings yield and US 10-year bonds.

Building a portfolio to withstand the impact of inflation

Given the unpredictable nature of inflation and its potential impact on corporate profitability and markets, the best advice is to build an equities portfolio that can weather its impact over the medium term.

Businesses that are capital-light, have a tailwind of demand, and possess the ability to raise prices will be well placed to withstand the emergence of inflation. A strong balance sheet will immunise the company from any rate rises associated with inflation.

While we can’t be certain of a new era of inflation, we can and must build portfolios to tolerate a variety of unexpected economic outcomes — inflation being one of them.

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MA Financial Group Limited, formerly Moelis Australia, is an ASX-listed financial services firm specialising in asset management, lending, corporate advisory and equities. For more of our insights, be sure to click the 'FOLLOW' button below.

Footnotes

1. Arthur Herman, Freedom’s Forge. Random House 2013.
   
2. ‘A history of Australian Equities’, Thomas Mathews, RBA 2019. (VIEW LINK)