The uptick in inflation as the U.S. has emerged from the pandemic lockdowns has caused investors to wonder what it means for markets. The last time the annual rate of year-over-year inflation exceeded current levels was 30 years ago in 1991. Since that time, inflation has gradually fallen. The pandemic reversed that trend. Is the low-inflation environment that has prevailed for a generation finally come to an end? What does that mean for stocks?
The unprecedented nature of the past 18-months likely explains much of the inflationary surge. The Covid-19 stay-at-home orders forced families and individuals to stock up on goods at the same time factories were going offline. This created a supply-demand imbalance – a classic recipe for inflation. Manufacturers faced with depleted inventories, labor shortages and supply constraints resulted in price increases. In an effort to counteract the pandemic’s economic impact, the federal government approved massive relief packages that likely further contributed to inflationary pressures.
The current direction of fiscal policy is toward increased stimulus while monetary policy remains expansionary. As employment trends continue to improve along with rising industrial production and sustained consumer spending, excessive inflationary pressures should wane over the second half of the year. Save for significant geopolitical risks, this is an excellent background for equity investments.
Need proof? The S&P 500 has returned +15% in the first half of 2021. If we were to close the books on the year right now, most investors would be pretty satisfied with their portfolio’s results. Bonds meanwhile have not been all that great, roiled by interest-rate and inflation worries. Traditionally that’s the case as inflation erodes the real or inflation adjusted value of bonds.
Higher prices across the economy are a main feature of inflation. In such an environment we want to own companies that have pricing power. Pricing power is the ability to raise prices without suffering a decline in revenue. Companies that have strong brands, monopolies, or products that represent a very small portion of customer budgets usually have pricing power. Your portfolio contains many such companies.
We believe investing in a diversified portfolio of financially strong, growing companies with high returns on invested capital will continue to be the better path for protecting and growing wealth. Many of the companies in your portfolios have the ability to manage inflationary pressures by raising prices, driving out inefficiencies within their organizations, and investing in technology.
Over the last century, the broad market returns have averaged approximately 10% per annum for equities and approximately 4% p.a. for intermediate bonds. Inflation has averaged approximately 3% per annum. Proper diversification, when achieved, enables investors to meet their withdrawal needs yet provide for portfolio growth to ensure purchasing power over the investor’s investment horizon despite the economic and investment climate of the time. Since inception, Cardinal has been dedicated to successfully building client portfolios with excellent risk and return characteristics whatever the economic and investment climate of the time may be.
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