- Our playbook for inflation investing comes in two stages.
- Stage 1 began in early June & should be shorter in duration.
- Stage 2 could last a year or two and few portfolios are positioned toward winners.
Our Inflation Investing Playbook
The distortions that have been created by COVID and the policies surrounding it continue to create noise across markets and corporate fundamentals. Make no mistake, the current market environment is one of the most unique I have seen in the 30 years I have been investing. I do not remember when so many macro factors had to play into our stock selection process. Supply chains have been disrupted, de-globalization is gaining momentum as countries and companies build new capabilities closer to home, and the price of almost everything is much higher than it was two years ago. Even as certain goods and services fall in price off lofty highs, they are likely to stabilize at higher levels than we are all accustomed to. If you have taken your vacation this summer, you have experienced higher lodging, food and beverage costs, air travel, and rental car pricing. Everywhere we turn, it’s more expensive.
As I listen to corporate earnings calls, the evidence points to companies that are continuing to raise prices to combat higher labor costs even as input costs for their businesses begin to roll over. In the most vital commodities, there continues to be a structural supply/demand imbalance which likely keeps prices higher for longer. Not to mention, from a geopolitical perspective, most countries that produce and sell commodities have a vested interest in keeping prices higher as the sustainable energy movement begins to take hold. Once inflation begins, it often gets entrenched for a period until demand falls and/or supply rises enough to push prices down. The bottom line: we are not going to see the Feds 2% inflation any time soon. That could keep the Fed more hawkish, interest rates well bid and volatile, and inflation higher for longer.
Consumers have already begun making decisions based on higher prices. There will be big winners and losers which makes stock picking a very important portfolio position for the next 12-24 months. Not every company is well suited for the environment we are in, and the most relevant brands will be taking market share. That’s where our team is focused from a stock selection perspective.
Stage 1: Investing in “Peak Inflation”
Just before the beginning of the June rally, positioning to equities was incredibly bearish, sentiment was extreme, and markets were very oversold. That is generally a pretty good set-up for a strong counter-trend rally. Markets rallied incredibly strongly, and the rally was very broad, which is generally very healthy. A few months ago, I noted that the first stage of this rally would likely come from the realization that a peak in the rate of change for inflation was in and inflation would slightly ease going forward. Thus far, we have seen this peak inflation reading and markets have responded favorably. The rally was likely robust simply because the entire market was positioned for max bearishness and increasing inflation versus a peak reading.
In my opinion, the Stage 1 rally has largely happened, and positioning is more appropriate for the market environment we are in. The Stage 2 portion of investing in an inflationary period should prove to be much longer in duration and will likely wear both bulls and bears out if their approach is buy & hold. Our base case is to be more active, trade the big ranges, and tilt heavily toward price makers, market share takers, and brands that sell products and services that are needed and or required. We are much more concentrated than normal because the market requires it.
Stage 2: Investing in “Structurally Higher Inflation”
If I had to guess, inflation is likely to average 4-7% for the next few years. The level is less important than the fact that inflation should stay elevated for longer than people think. In a period when growth is constrained and inflation stays elevated, the traditional 60/40, 70/30 portfolio likely underwhelms advisors and investors. Not every stock performs well, and bonds will likely be much more volatile than any of us are comfortable with.
The Playbook: 1968-1975
During this period, inflation averaged about 6.3% and was not transitory. Because of the structural imbalances across much of the commodity complex, housing stock (rentals in particular), and stubbornly higher labor shortages, it is not difficult to make an inflation call for “higher for longer.” Countries across the world witnessed how vulnerable their supply chains are and the friction between the West and China seems only to get more acute. If we look back at former periods with higher inflation, the 1968-1975 period seems quite similar, although not exactly the same. Here’s a chart and summary of this period as a guidepost:
- S&P 500 annualized return for 8 years was ~3.3% for a negative REAL return.
- Inflation as measured by CPI averaged ~6.2%
- Wild volatility across the interest rate, commodity, and equities complex.
- Big drawdowns: -36%, -14%, -48% mostly tied to up trending CPI & interest rate readings.
- Big rallies: +51%, +33%, +53% mostly tied to stubbornly high but falling CPI & interest rate readings.
- Interest rates as measured by the 10 Year Gov’t bond averaged 6.6%.
Investors have been blessed with low and falling rates, cheap access to capital, an accommodative central bank, low inflation, and stable growth since 2009. That environment has favored a basic stocks, bonds, and cash type of portfolio. With rates higher (and likely to be volatile), inflation sticky and higher for longer, a hawkish Fed and higher cost of capital, valuations for most stocks should be lower than the last 13 years and will become much more important, the quality of the balance sheet and business becomes more important and being the price maker and market share taker is vitally important for better forward returns than the indices might offer. Portfolios need more exposure to price makers, leading companies that set prices and have loyal customers and/or that are the go-to brands for the business they are in. Ones that manage their businesses well and can offer attractive pricing to consumers while not suffering from the margin erosion (Costco comes to mind) that second and third tier companies will experience.
One key mega-trend we have been talking about for 6+ months is the massive migration of assets from traditional stocks and bonds to alternative assets like inflation-protected bonds, real assets, commodities, real estate, and other assets that have inflation kickers built into the business models. That’s why our consumer brand focused Fund’s top two holdings are Blackstone and KKR. They have been investing assets into inflation winners for many years and have a combined ~$300 billion of dry powder to take advantage of the distress created by structurally higher inflation, volatile markets, and illiquid credit markets. We also have an overweight position in the leading energy brands – Chevron & Exxon – that should benefit from a poor supply/demand picture and higher and stable commodity prices.
The next few years should be very different than we are accustomed to, and they will require a different asset allocation than we have needed for the better part of 35 years. When the facts change, the allocations also must change. Carpe diem!
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