Best stocks/sectors for higher inflation

[Cigarbutt]

In the mid-1960s, inflation had been low and stable for many years, leading to low and stable inflation expectations. It wasn't until unemployment moved more than a percentage point below estimated levels of the natural rate of unemployment during 1965 that inflation began to increase.

Between 1965 and 1966 inflation jumped from 1.5% to more than 3%. A couple of years later, it had doubled again.

Based in part on this, Stock and Watson (2009) concluded that inflation does not begin to respond significantly to labour market tightness until unemployment falls 1 percentage point or more below the natural rate.

https://voxeu.org/article/phillips-curve-dead-or-alive

Unemployment rate 3.6%

Natural rate ~4.4%

 

Thinking about Vanguard's CCF fund.

Commodities are well-correlated to unexpected inflation and have sufficient beta to provide a higher degree of inflation coverage...

https://advisors.vanguard.com/iwe/pdf/ISGCTIPS.pdf

I'm not sure the following is helpful (for you) but just in case.

The commodity space now, from a bottom-up perspective, contains many interesting pockets of value and a basket or fund approach may make sense. However (and maybe this is a mistake on my part), putting specific investments in a more global or macro context has made me hesitate (contrary to many other times before). Here's a take 1-on why the input described in your post, by itself, should not be used for a long position in commodities and 2-on another conclusion.

 

The Phillips curve is interesting but has been denatured and its significance has been significantly overstated. The fact that this model is still a fundamental input at the Fed constitutes another conundrum. The initial work showed a potential correlation (not a cause and effect) between wage inflation and unemployment (common sense applies here) but the conclusions have been stretched to causality and general price levels often with little more than artificial hypotheses, not connected to real data, common sense or a more global interpretation. For instance, in relation to what is described in your post, in the last 10 years, using the Phillips curve model, the Fed has repeatedly made forecasts overestimating the expected levels of inflation and the expected expected (!) levels of inflation. An argument is that one day this will occur but I'm not so sure as it may take much longer than expected for true inflation forces to take over the amazingly strong deflationary forces built in the present economic system.

 

My point is that (if this is useful at all) the key inputs of the Phillips curve need to be interpreted in a larger context. Mr. Paul Volcker (a hero of mine so potential bias) is now celebrated by most for his many accomplishments including the "fight" against inflation. What some people forget is that he went against the crowd at many levels. Inducing a recession meant he received car keys (car dealers and car owners), pieces of 2x4 (construction workers and entrepreneurs) and angry letters. It also meant that he had to fight the majority-held view by the 'experts' who believed in the Phillips curve, implying that lowering inflation would cause an increase in unemployment (the classic inverse relationship). Even if true in a limited way, Mr. Volcker patiently and courageously explained that the Phillips curve did not apply in that particular context and the best way to lower unemployment in a sustainable way was to lower inflation (contrary to the model 'projections'). In that case, I would say the historical record wins over the theoretical objections. How about today? What is amazingly surprising, for some, is not the tepid rise in wage inflation over the last few years, it is the absence of it, given where we are in the cycle and given the historically low unemployment levels. The point about the present global context (and its relevance to commodities) is that inflationary forces are unlikely to win, given the unprecedented leveraged status of the global and connected economy. Inflation will creep in (IMO) only if there is significant questioning about the relative values of currencies or once a deleveraging (for real) has occurred, both scenarios negative for commodities. Given that type of reasoning, in order to best reunite circumstances for a favorable outcome in commodities, the Fed should raise rates now but NOBODY in their right mind would consider that, at this point. I continue to think that a lot of the deflationary forces are at the gate and will not invest in commodities until I'm convinced otherwise.

[petec]

This is something I have been thinking about for a while, without reaching many actionable conclusions.

 

On the very long term, the best inflation hedges are capital-light equities with pricing power.

 

However, in the short term (when it becomes apparent inflation is rising) it's quite possible that rising discount rates will hurt the stock prices of growth stocks (where the cash flows are in the future) more than traditional value stocks (where the cash flows come sooner). This would be the reverse of what's happened over the last 10y.

 

I think, therefore, there is some value in owning a few traditional value stocks so long as they don't need much maintenance capex and don't have short term debt.

 

I would only invest in levered equities if they have long term fixed rate debt that can get inflated away. Short term debt that needs to be rolled onto higher interest rates won't help.

[james22]

Thanks, Cigarbutt.

 

I continue to think that a lot of the deflationary forces are at the gate...

 

I agree, I don't expect inflation.

 

But commodities hedge against *unexpected* inflation. If I bought, would be as insurance against my expectation.

 

And out-of-favor, they maybe undervalued?

 

The best time to get interested in an investing strategy is when its performance is at its worst. By that standard, commodities are starting to look intriguing.

 

These assets—oil and gas, corn and wheat, cattle and hogs, nickel and tin, silver and gold and so on—have been stinking up the joint ever since investors raced to buy them during the financial crisis.

 

https://www.wsj.com/articles/its-slow-going-but-stuff-like-wheat-and-oil-can-spice-up-your-returns-11574437225

[MrB]

During the years leading up to the GFC we spent a considerable amount of time and resources studying inflation in general and high inflation in particular in order to find the perfect solution. The short answer is, there is none. Logically this should not be surprising, because inflation at the core is confiscatory. It's government's way of meeting debts it cannot pay, which can only be paid by those that own assets (you).

At the end of the day it's not whether you will be hurt by inflation, but how much you will get hurt. The Weimar Republic, Zimbabwe, etc make for great case studies. One particular problem is that in reality inflationary periods that you have to navigate tend to be long. The hyper/high inflation might not be that long, but the lead up usually takes time.

 

Conclusion was, which again should be unsurprising, the best way to minimize the damage from inflation is to be in companies with high pricing power. At the end of the day any company with high relative bargaining power in the economy will be able to protect the buying power of its owners' assets the best.

Not rocket science. I don't think we had to spend all that time and money to figure out something, which at a basic level is actually quite obvious. It's just another family paying off a wayward family member's debt.

 

[sleepydragon]

Long companies that doesn’t need capitals and can raise prices. WEB said that many times in his letters. But such companies all are trading at very high PEs nowadays (except cigarettes companies)

[petec]

Long companies that doesn’t need capitals and can raise prices. WEB said that many times in his letters. But such companies all are trading at very high PEs nowadays (except cigarettes companies)

]

 

Hence my point about the initial impact of changes to discount rates.

 

The other issue (raised above) is that many of the companies that used to have pricing power don't any more. Inflation is highly like to squeeze some margins. And with margins at all time highs it may even be that high margin companies choose not to fully protect margins for political/perception reasons.

 

As to whether we will have deflation or inflation, that's a political decision and I suspect the political winds favour inflation. But that's in the long term. We might well get a short bout of deflation followed by Yang-style helicopter money.

[scorpioncapital]

"On the very long term, the best inflation hedges are capital-light equities with pricing power."

 

Why can't you have a capital intensive monopoly like a utility or railroad with pricing power? Governments define acceptable returns in real terms so I see no regulatory issues.

 

As for the claim that inflation is a tax on assets, it's not. It is precisely those with assets that Dodge the inflation. Inflation is a tax on saver or cash. And what is the difference between financial repression which we have now and inflation. The result is the same, savers and pensions are moaning that real rates are negative

[Guest Schwab711]

SCHW is becoming a more direct bet on interest rates in the short-run since their model has shifted heavily towards the spreads on margin loans and cash sweeps.

[Jurgis]

SCHW is becoming a more direct bet on interest rates in the short-run since their model has shifted heavily towards the spreads on margin loans and cash sweeps.

 

What do you think about SCHW? (Maybe we should move discussion to SCHW thread). It has done very well historically, it seems to drive the changes in brokerage industry and do quite well in sidelining competition. OTOH, I wonder if zero commissions will launch even more aggressive competition across the field with everyone losing more than gaining. Also, as you say, it will be impacted by narrowing margins if rates stay low.

[LC]

"On the very long term, the best inflation hedges are capital-light equities with pricing power."

 

Why can't you have a capital intensive monopoly like a utility or railroad with pricing power? Governments define acceptable returns in real terms so I see no regulatory issues.

 

As for the claim that inflation is a tax on assets, it's not. It is precisely those with assets that Dodge the inflation. Inflation is a tax on saver or cash. And what is the difference between financial repression which we have now and inflation. The result is the same, savers and pensions are moaning that real rates are negative

My take is that capital heavy industries require capital upkeep. This upkeep is subject to inflation so while you may come out slightly ahead depending on the change in magnitude of your pricing power vs. your suppliers, it is not exactly a thrilling experience.

 

On the second item. Savers invest in assets, so saying that inflation is a tax on savers but not assets somewhat puzzles me.

 

Inflation is really a tax on inaction and value-destructive activity, i.e. un-productivity. Those who hoard their capital (inaction) are hurt by inflation as their purchasing power erodes. Those in value-destructive industries will naturally be eroded as their costs increase faster than their revenues. Inflation rewards those who can charge increasing revenues without significantly expanding their costs.