Inflation has been a rising devil for some time now. It started with the US recording high inflation thanks to all the stimulus and a super-tight employment market, and then moved to fears of the Fed reversing its longstanding policy to curb inflation, to finally Russia’s conflict with Ukraine and subsequent sanctions on Russia triggering massive hikes across commodities, for the whole world.
Inflation is okay for the headlines. But it’s when price get raised that the pockets start getting lighter. And then investments start getting eroded at the same time. So now you have lesser money, and you have to pay more for things. What should one do then? Where do you invest to be able to save your money from reducing in value?
The impact of inflation on different asset classes
Inflation is a weighted index of prices for a basket of goods and services. Take commodities for instance, these are the the physical assets like corn, wheat, rice, etc. Their prices are what define the underlying inflation. This means commodity prices will rise along with inflation. Commodities tend to be a great hedge against inflation.
Similarly gold is a store of value as it is a precious metal - ultimately a commodity. Buying gold is the best inflationary hedge as it is seen as a safe haven. Investors tend to fancy adding gold each time risk aversion in the market increases. Even during the war, all asset classes other than gold were losing value.
Fixed income securities (debt) has an inverse relationship with inflation. Here’s why. When inflation rises, central banks increase interest rates to slow things down. When interest rates rise, bond prices fall down. In this scenario, long term bonds tend to see larger price depreciation compared to shorter term bonds. To lose lesser, it is safer to move to shorter maturities. This is exactly what we did in Rupeeting’s Core Portfolios in January 2022 - we reduced the duration of our debt exposure from 10 years to 5-7 years.
Equity markets tend to react negatively to inflation in the short-run, but beat inflation in the long-run. In the short-term, there are a few things that impact stock prices:
Lower revenue growth - Higher prices make people buy lesser, impacting revenue growth for companies
Higher costs - Input costs (fuel, materials, packaging, wages) rise for companies resulting in lower margins
Higher interest - When inflation rises, central banks raise interest rates to slow things down. This increases interest payments for all companies that have floating-rate debt
Lower profits - Lower revenue growth and higher costs tend to erode company profits
Lower valuations - Simplistically, a stock price is the discounted sum of all future cash flows of the company. If the discount rate (linked to interest rate) itself increases, stock prices tend to go lower
But this can’t be true for equities uniformly. Stocks with lower impact from the above factors tend to perform better, and being invested in those would end up in market outperformance.
Where within equities can one invest?
We can go in the same sequence as above to highlight what can be good investment options.
Companies with higher price inelasticity - Take Pharmaceuticals and Healthcare for example. People will buy medicines, use diagnostic services and pay for insurance irrespective of how expensive other things are getting. Similarly, these days people pay for data consumption and Telecom services despite price increases in other areas of their lives.
Companies with cost buffers - One of things that easily gets impacted during inflation (and even causes it) is crude. Companies with higher dependence on crude as a cost tend to perform worse. Even worse are those with high crude dependence and inability to pass the cost increase on in the form of a price hike - take Paints for example. Whereas if infrastructure demand is great and buyers are wholesale, Cement prices hikes are digested by the market.
Companies with lower debt - Any company with high debt would find it hard to service that debt when revenues and profits are declining, and even more when their debt is not at a fixed rate. Companies with large cash balances and no (or little) debt tend to perform better. Technology Services companies are a good example. On the other hand, Real Estate companies are highly leveraged, and consumption slows down because of a high ticket size and dependence on debt for consumers to purchase.
Companies with higher margins - Companies with higher margins are able to absorb the pressures of lower growth and higher costs better. Some examples - Established Internet companies like Info Edge, Asset Management Companies, Exchanges, Broadcasting Companies, and Telecom Service Providers.
Companies with valuation buffers - Companies that are low on earnings, but high on valuations tend to underperform during these times, as valuations get hit. And since most of the stock price is made of valuations in their case, they take a larger beating. Internet companies for example. In general, growth attracts higher valuation. And investors tend to move from growth to value.
What changes should one bring in their portfolios?
In a nutshell, here’s what one can do with their portfolios during inflation:
Take some Commodity exposure
Increase exposure to Gold
In Debt - Reduce Maturity, Improve Credit exposure, Add Floating Rate instruments
In Equity - Add defensives, look for growth pockets, reduce crude exposure, add companies with healthy balance sheets, add companies with strong financials and operating margins, reduce exposure to growth and increase exposure to value, focus more on bottom-up than top-down