Dear Clients and Friends of Insight,
In our April letter we expressed concern that accelerating economic growth due to pent up demand, supported by massive government spending and stimulative monetary policy, yet constrained by supply disruptions, would likely lead to higher inflation. We began discussing the implications for investors if these expected situational price increases become persistent in the years ahead.
We have discussed the implication for bond investors, which is bad. Bond owners receive recurring interest payments, which are generally fixed, over the life of their bonds. As costs rise due to inflation though, these future interest payments and the eventual return of principal at maturity are worth less in future purchasing power. Thus, all outstanding bonds become less valuable to investors today, pressuring their prices to decline and their yields to rise. And, if the rate of inflation exceeds the interest rate a bond pays its owner, then the inflation-adjusted (real) return for the bond owner is negative. Inflation is a severe risk bond investors face today, though the severity of this risk varies across bonds depending on their specific parameters.
Let us now turn our attention to the implication for stock investors, which is mixed. A company’s stock price today is determined by its expected future earnings. In general, a company with higher expected future earnings is more valuable than a company with lower expected future earnings. This future stream of earnings for stocks, though variable and uncertain, is analogous to the future income payments from bonds, which are generally fixed and predictable. Thus, like our assessment of bond prices above, inflation reduces the purchasing power of future earnings which reduces a company’s current expected value and pressures its stock price to decline. This is a considerable risk for stock investors, though this risk, too, varies across stocks depending on their specific characteristics.
True to form, recent economic reports confirm that prices have increased considerably this year for many goods and services. The “informed” consensus is that these inflationary conditions will not persist, but rather will be transitory and should not worry us. Here is their basic reasoning:
- Due to the dramatic closing and re-opening of global economies, year-over-year comparisons of economic statistics are misleading and difficult to interpret.
- The surge in demand has strained global supply sources, transportation systems and commodity supplies, but these pressures will subside as global economies continue to rebound.
- The labor shortage for many industries is temporary and will not lead to ever-rising labor costs as employers and workers adjust to structural changes in the post-pandemic economy.
- The deflationary impact from an aging population will continue to restrain price increases.
- Productivity gains from innovation and the continual automation of our economic activity will enhance economic output considerably and more than enough to compensate for increases in labor and supply costs.
We are skeptical that this reasoning will hold true over the next several years and believe investors should be positioning their portfolios in anticipation of a period of extended inflation. For bond allocations, this means owning higher quality bonds with shorter maturities while delaying additional purchases until interest rates rise to levels that better represent the potential inflation risk ahead. For stock allocations this means investing in companies that:
- Are financially strong and can self-finance their future capital investment needs.
- Have predictable and sustainable revenue growth that leads to predictable and growing earnings streams.
- Reward their shareholders with growing dividends and meaningful share buybacks that together yield a current cash return to owners that exceeds future expected inflation rates.
- Are valued reasonably relative to their fundamental business conditions and likely future results, which provides investors with a margin of safety in case expectations are not met.
Unlike many of today’s market participants, Insight’s clients have for decades worked hard and saved carefully to accumulate their wealth. Now, preserving the principal and their principal’s future purchasing power is of paramount importance. Our clients can take comfort knowing that our investment decision-making discipline is founded on this primary goal.
INSIGHT INVESTMENT COUNSEL