The Myth of Stocks as an Inflation Hedge
With inflation voraciously eating away at the dollar, uninvested cash quickly becomes a drag on every investor’s portfolio. With the current overall CPI over 8%, a $100,000 balance placed in a savings account loses over $650 per month in purchasing power. This alarming erosion of value will have even the most conservative investors looking for fortifications.
Traditional asset classes currently offer little protection against the ravages of inflation – the entire bond universe (including those below investment grade) is yielding well below the CPI rate; real estate offers no recourse either (the ceiling rates on most classes of real estate fluctuate between 3% and 6% today).
That leaves equities – and, at first glance, they seem like an attractive option. After all, when input costs rise, companies can simply raise the prices of their products and thus retain their earning power. But the reality is a little more nuanced than that.
Inflation: the good, the bad and the ugly
The widespread belief that business results are inflation resistant rests on the simplistic assumption that as input costs (mainly wages and raw materials) rise, the price of the final product may also rise and , therefore, the net impact on a business is neutral. This heuristic shortcut used by many investors overlooks several subtleties, I go into some of them below.
Businesses benefit from favorable outcomes of inflationary forces – although they only occur during the early stages of inflation and only benefit certain types of businesses.
During the initial period of onset of inflation, businesses benefit from lower input costs, usually in two areas – raw materials and labor. An immediate short-term increase in revenue comes from expanding margins when inventory purchased in older, cheaper dollars is now sold as finished goods at newer, higher prices. Wage costs also lag behind fully catching up with inflation – mainly because workers’ salaries are usually only revised once a year; and in the case of unionized or collective bargaining situations, these are often contractually locked in for several years (most collective agreements have removed cost-of-living adjustment clauses over the years – even though they now do their return).
Firms with high fixed costs also enjoy certain transitional benefits during periods of inflation. Players in industries such as heavy manufacturing, pharmaceuticals, airlines, etc. have to make large capital expenditures to build factories, buy equipment, invest in large R&D projects, etc. before they can start profitable production and sales. These types of businesses are positively impacted by inflation in two ways.
1. Improved cost structure: A business that has a large fixed cost suffers from a drag on profitability until it breaks the break-even point between sales and fixed costs. Once that happens, profitability skyrockets on all subsequent incremental sales. Inflation makes it easier for businesses to break even – since fixed costs were incurred using fewer dollars in the past, while current sales are valued in more inflated dollars. The result is that sales benefit from an “increase in profitability” sooner and achieve higher margins faster.
2. Widening the moat: in an inflationary environment, established players who have already paid their “capex” (via large investments previously committed) erect a barrier against new entrants. Any potential new entrant will face a competitive disadvantage, as they will have to pay a higher cost to achieve output parity and, in addition, will suffer from continued depreciation of larger fixed costs.
However, none of these benefits last: as aging equipment will eventually need to be replaced (more on this later).
Another transitory advantage that firms enjoy during the early stages of inflation is the lag between inflation rates and interest rates. During this lag, inflation rates outpace borrowing costs, creating a “free ride” that contributes to the temporary widening of profit margins.
Although companies can exploit the lag between labor, inventory, investment and borrowing costs to catch up with inflation, these gains will eventually dissipate. Bad and ugly results will then start to appear. Let’s start with the bad.
In the context of inflation, the bad news for investors is that the return a company earns on its equity (RoE) does not vary greatly between inflationary and non-inflationary environments – this is because inflation has an equal impact on all inputs that determine the RoE, canceling each other out. Warren Buffett’s classic 1977 article on inflation describes this phenomenon in detail.
The result is that owning shares in a company that earns 12% RoE becomes much less attractive when inflation is 8%, compared to when inflation takes a small bite of 2%.
The ugly one
The longer inflation persists, the more its effects are ruinous on corporate returns and therefore on ownership shares in them. The main variables creating these deleterious effects are as follows.
1. Interest rate: Inflation is a blessing for those who borrowed and a curse for those who lent. This is because borrowers pay interest (and principal) in the inflated new dollars, while lenders originally lent in older, more valuable dollars. But lenders won’t want to play this game for long: when new loans are made or when debt is rolled over, they’ll charge interest rates that offset inflation, driving up borrowing rates. Higher debt service charges will of course lead to lower corporate profitability.
Moreover, a rise in interest rates has a multiplier effect – it increases the costs of financing throughout the company’s supply and value chain. The cumulative impact of higher interest rates on businesses is therefore acute.
2. Replacement Capex: Maintaining a company’s production capacity requires continuous capital expenditure on fixed assets (plants, fixed assets). However, higher inflation-induced replacement costs are eating away at the company’s cash flow. As inflation escalates, companies are burning more of their cash just to stay put.
3. Pricing power: Although some of the cost escalation caused by inflation may be passed on to consumers, the fear of losing market share acts as a brake on this. Very few companies have real pricing power; in most cases, market forces conspire against a company’s ability to easily raise prices. This limited pricing power further compresses margins and profitability.
4. Taxation: In many major tax jurisdictions (domestic and global), income tax brackets are subject to fixed thresholds and are not indexed to inflation. The net effect is that when inflation increases a company’s nominal income, it is pushed into higher tax brackets, although no increase in real income has occurred. This so-called “slice creep” further erodes corporate profitability.
The Gravitational Pull of Inflation: What Can Take Flight?
Given all of this, are there any industries or sectors that can overcome the pull of inflation? Companies that have incurred high fixed costs in the past have long-lived productive assets, require minimal replacement expenses, and have low variable costs are potential candidates. What is that? Non-leveraged REITs, logging companies, and mining and oil/gas royalties fall into this category. Companies that have strong pricing power (and generally have a strong brand customer base) are also likely to remain strong.
The bottom line is this: in an inflationary environment, the combined impact of higher interest rates, corrosive replacement investments, limited pricing power, higher tax rates and Stagnant returns on equity weigh on company performance, and therefore make stocks a weak hedge against the ravages of inflation.