Equity investing in an inflationary environment: which companies could succeed?

Inflation is not necessarily bad news for equity valuations. Some inflation can be beneficial for companies’ bottom lines as it allows them to raise prices and protect profitability in ways they may not have been able to do in recent years. It also helps selective banks and commodity-linked companies that have struggled in a low inflation, low interest rate environment.

Even during times of higher inflation, stocks have generally provided positive real returns. Global equities have historically provided an effective inflation hedge when US inflation is between 2-6%, powered by real earnings growth and real dividend growth. It’s mostly at the extremes (when inflation is above 6% or negative) that global equities have tended to struggle.

However, sustained periods of elevated inflation are rare. The ultra-high inflation of the 1970s was a unique period, while deflationary pressures, such as during the Great Depression, have often been much more difficult to tame. 

Impact on sector behaviour can vary 

History shows that some companies and industries have delivered fairly consistent relative returns during past inflationary environments, while others are more of a mixed bag.

The chart below shows how different US equity sectors have performed during periods of higher inflation (above 2%) and during periods of lower inflation (below 2%). The ‘hit rate’ is the percentage of periods when a sector achieved a return higher than the Standard & Poor’s 500 Composite Index (S&P 500).

While the hit rates are within quite a narrow overall range, there do appear to be some trends. During periods of higher inflation, real estate, consumer staples and health care outpaced the S&P 500 in more instances than other sectors. Whereas consumer discretionary and information technology outpaced more when inflation was low (below 2%).

The channel through which inflation impacts sectors can vary widely and often the impact is through second derivative effects such as growth and interest rates.

Sometimes sector behaviour is a direct impact of inflation, notably with Consumer discretionary. Consumers’ discretionary spending is impacted by higher borrowing rates and also energy prices (specifically, gasoline). As the consumer burden decreases (falling inflation), the outlook for consumer discretionary can improve relative to the broader market. 

Sector behaviour can also be driven by the impact of inflation on the economy and this is seen with consumer staples. When the economy moves into distress and consumer spending declines, the consumer staples sector, which generally benefits from stable consumer spending patterns through a cycle, can do well relative to the broad market. Similarly, when inflation starts to decline and the economy recovers (along with consumer spending recovering), other sectors can recover and consumer staples may lag. 

And other times, sector behaviour is driven by what is happening to interest rates. Companies for which interest income is a meaningful part of their business, such as life insurance companies and banks, will benefit in a period of higher interest rates which generally accompanies higher inflation. 

While there are some similarities in sector behaviour during past inflationary episodes, there are enough differences in terms of the drivers and the market environment.

These call for careful assessment when making strong conclusions about what could happen in the current environment. Nevertheless, a positive characteristic to consider when investing in an inflationary environment is companies whose top line can ‘inflate’ at a higher rate than their costs. 

Addressing a higher inflation and interest rate environment 

With inflation proving more persistent than central banks had initially thought, it is likely that rising costs will linger in the months ahead. Companies with high average gross margins and low debt may be better suited to weather this new environment.

In particular, we believe that companies that could succeed in such an environment include those that provide essential services, like health care giants Pfizer, UnitedHealth Group and Abbot Laboratories. The average gross margin in the Pharma/Biotech sector tends to be around 65%.  

The same could be said for businesses with quality products. Tesla’s technological lead in electric vehicles has allowed it to pursue a highly dynamic pricing strategy. In March 2022, Tesla increased prices across its entire range by as much as 10%.  

2021 saw global dividends recover very strongly, more than making up for the cuts made during the worst of the pandemic in 2020. Looking ahead, dividend-income investment could well play a more important role in the total return of a portfolio. Dividend-paying stocks provide a combination of income along with the potential for capital appreciation – especially since the valuations of many of these companies appear reasonable following a long bull market for growth stocks. However, it’s important to be cautious on companies with heavy debt loads or excessive leverage on their balance sheets in a rising rate environment.

Lastly, companies that enable cost efficiencies are also primed to perform across a challenging market period. Cloud infrastructure and software-as-a-service have seen strong uptake as network and scale effects drive structural reductions in unit costs. 

Conclusion 

Over the past decade, many growth companies have been rewarded in an environment of modest global economic growth, very little inflation and ultra-low interest rates. We now appear to be in the early stages of an equity market that is starting to show some breadth after a heavy focus placed on technology-related growth stocks in the IT, consumer discretionary and communication services sectors.