Inflation — and Why It Matters to Investors
Everything about investing changes in an inflationary environment. Charlie Bobrinskoy explains why investors should care about the implications of rising inflation.
For members of my generation, inflation has also been a force that casts an enormous shadow over our investment decisions. When I was young, inflation may well have been THE most important investment factor. From 1966 through 1992, inflation was never less than 3 percent and was as high as 13 percent.
Since 1993, subdued inflation has created a whole generation of investors unfamiliar with the impact of always-rising costs. Low inflation also allows purchasing power to remain roughly the same, so a dollar of earnings 10 years ago is worth roughly the same today. Low inflation is one reason growth stocks have outperformed value stocks and why high dividend-paying equities are popular. It’s also one reason why capital-intensive investments like master limited partnerships have flourished.
An Inflation Primer
There are lots of ways to measure Inflation, but two of the most popular are the headline consumer price index number, which measures all consumer goods, and the core index, which excludes volatile food and energy prices. The core index has not reached 3 percent since 1993.
Over the 12 months, ended November, 2018 headline CPI rose to 2.2 percent, which is above the Federal Reserve’s 2 percent inflation target. Does this signal inflation’s return? Perhaps. It could be a warning sign for investors.
Although it is true that those of us scarred by inflation’s impact in the 60s and 70s tend to see it around every corner, it is not the first time I have emphasized rising inflation risks. However, there are signs the low inflationary environment we’ve enjoyed since 1993 is going to change, and investors who ignore higher inflation may be in for a rude awakening.
What Has Kept Inflation So Low and What Forces are Pushing Inflation Higher Now?
For the past 30 years, the U.S. was seen as the safest place to make financial investments. To purchase dollar-denominated securities, non-U.S. investors had to buy dollars, keeping the greenback bid up. A stronger dollar is all about trust and confidence. Inflation has been kept in check by the strong dollar.
But there are signs the U.S. dollar may be weakening. When this happens, the purchasing power of the consumer decreases. A weaker dollar, in turn, will lead to higher inflation.
Let’s examine the factors that may begin to weigh more heavily on the dollar. First, there has been a dramatic increase in our borrowing levels as the federal debt now exceeds $22 trillion, versus less than $10 trillion 10 years ago. The U.S. government continues to run a large fiscal deficit with no end in sight. Most notably, the Chinese government has been the largest purchaser of U.S. government securities, as China had massive inflows of dollars from a trade surplus.
Secondly, as America seeks to sharply reduce its trade deficit with the rest of the world, global demand for U.S. dollars will slow.
Thirdly, record-low unemployment causes upward wage pressure and often leads to legislation that raises the minimum wage. Both Democrats and Republicans want to repatriate manufacturing jobs, and a weaker dollar increases the likelihood this will happen, giving politicians an incentive to “talk the dollar down.” This decreases the greenback’s value and increases inflationary pressure. We are already seeing signs of higher wages, with the December jobs report showing wages have increased 3.2% versus a year ago.
Finally, technological advances have done little to increase productivity, which normally tames inflation. Past discoveries have improved efficiency in travel, communication, food production and manufacturing. Today’s technology improvements seem to be concentrated in social media, which, arguably, reduces productivity. Social media entrepreneurs do not reduce costs in the way industrialists like Henry Ford, John Rockefeller and Thomas Edison did.
What Implications Does Rising Inflation Have for Investors – And Why Should We Care?
As investors, we should care about the implications of rising inflation because everything about investing changes in an inflationary environment.
Inflation directly ties into interest rates. There are two main components to interest rates—the risk of default and the time value of money. In an inflationary environment, lenders demand higher interest rates on their loans to compensate them for the increased time value of money. Borrowing becomes costlier. That affects the world’s biggest borrowers, U.S. home buyers, and can ripple through to home construction, the largest part of the U.S. economy.
In this type of environment, investors need to beware of long-term fixed-income securities, which could become an investment trap. For example, a 30-year bond with a 3.75 percent coupon might look tempting, but not after the purchasing power of later payment is properly calculated. Fixed-income investors may frown on companies who use leverage to make investments, buy back stock or make acquisitions. The bond-substitutes like MLPs and utilities will be hurt by higher rates as it becomes costlier to finance their capital-intensive general operations.
Growth stocks could also be a costly investment mistake, because a dollar earned at some distant point in the future will be worth less when discounted at a higher rate. Investors may become less willing to part with today’s hard-earned cash for the promise of future dollars, which have lower purchasing power.
What Types of Investments Might Be Expected to Perform Well in an Inflationary Environment?
Investments that traditionally perform well in inflationary environments and often act as hedges to rising prices include hard assets like farmland, oil in the ground, fertilizer, materials and gold.
How rising inflation affects corporate real estate remains a question. For many years, the real estate investment trust sector benefitted from cheap financing, so rising rates will be a challenge. On the other hand, real investment trusts could have a natural hedge of owning real assets.
Investors should also be cautious with financial institutions like banks. Asset-sensitive banks with variable-rate loans that can rise as interest rates increase can do well in a higher inflation environment. Liabilities-sensitive banks who must borrow in floating-rate market while holding fixed-rate mortgages can perform very badly. This in fact was the cause of the 1970s savings and loans crisis; their portfolios of fixed-rate mortgages declined in value while funding costs skyrocketed.
As a general rule, quality companies do well in an inflationary environment. Quality companies have high returns on equity, high operating margins and low debt. Wide moats like high barriers to entry allow them to pass through rising costs which protects their pricing power.
How Does Ariel Seek to Insulate its Portfolios from Inflation?
At Ariel, we are cognizant about the risks that inflation poses to our portfolios, but select investments that we believe will withstand inflationary pressures.
We believe companies with pricing power include those in consumer staples, like The J.M. Smucker Company (SJM), or healthcare companies, like Johnson and Johnson (JNJ). Natural resource companies, like Exxon Mobil (XOM), with its access to oil deposits, have done well historically in an inflationary environment. We view quality companies as those with wide moats and possessing pricing power, and they are the types of investments we seek to invest in for our Ariel investment portfolios.
These opinions are current as of the date of this article but are subject to change. The information provided in this article does not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular security.
Ariel Focus Fund is a non-diversified fund and therefore may be subject to greater volatility than a more diversified investment. Investing in equity stocks is risky and subject to the volatility of the markets. Investing in small- and mid-cap stocks is more risky and volatile than investing in large-cap stocks. The intrinsic value of the stocks in which the Fund invests may never be recognized by the broader market.
Investors should consider carefully the investment objectives, risks, and charges and expenses before investing. For a current summary prospectus or full prospectus which contains this and other information about the funds offered by Ariel Investment Trust, call us at 800-292-7435 or click here. Please read the summary prospectus or full prospectus carefully before investing. Distributed by Ariel Distributors, LLC, a wholly-owned subsidiary of Ariel Investments, LLC. Ariel Distributors, LLC is a member of the Securities Investor Protection Corporation.
Portfolio holdings are subject to change. The performance of any single portfolio holding is no indication of the performance of other portfolio holdings of the Ariel Focus Fund or of the performance of the Fund itself. Click here for the most recent holdings for the Ariel Focus Fund.
Bonds are fixed income securities in that at the time of the purchase of a bond, the amount of income and the timing of the payments are known. Risks of bonds include credit risk and interest rate risk, both of which may affect a bond’s investment value by resulting in lower bond prices or an eventual decrease in income.
A REIT (real estate investment trust) is a security that invests in real estate. REITs receive special tax considerations, have potentially high yields, and offer a liquid method of investing in real estate. Risks include interest rate and overdevelopment risk.
MLPs have risks that include governance features that can favor management over other investors, potential conflicts of interest, and concentrated exposure to a single industry or commodity.
Utility stocks tend to offer high-yield dividends, though the prices are unlikely to fluctuate. This reduces the potential for capital gain and presents the risk of loss.
Consumer staple stocks are considered to be noncyclical in that the demand for the products made by these companies does not decrease in a recession. Consumer staple stocks have historically experienced lower volatility.
Prices of hard assets, such as farmland, oil in the ground, fertilizer, materials, and gold, can be significantly affected by events relating to their industries, including international political and economic developments, import controls, worldwide competition, government regulations, economic conditions, inflation, and other factors. Hard assets may experience substantial price fluctuations as a result of these factors.
A growth investment strategy seeks stocks that are deemed to have superior growth potential. Growth stocks offer an established track record and are perceived to be less risky than value stocks. A value investment strategy seeks undervalued stocks that show a strong potential for growth. The intrinsic value of the stocks in which a value strategy invests may be based on incorrect assumptions or estimations, may be affected by declining fundamentals or external forces, and may never be recognized by the broader market.
Return on Equity: A measure of a corporation's profitability that reveals how much profit a company generates with the money shareholders have invested.