Navigating Inflation: Does Your Concern Match Your Hedge?
As the chorus of inflation concerns grows louder by the day, it’s important to take a step back and remember that inflation is not inherently bad. Inflation, nominal GDP, and corporate sales are all highly correlated. When prices rise gradually, it’s an indication of positive economic momentum. This important detail is often lost in the echo chamber of headlines that like to paint all inflation scenarios as nefarious.
Since the publication of our annual outlook, we have maintained the view that inflation is more of a “cyclical” phenomenon rather than a “structural” risk. Structurally “bad” inflation is defined by rapidly increasing input costs that cannot be passed on to consumers, a dynamic that helps feed a vicious feedback loop of higher unemployment and declining nominal GDP. In the U.S., this type of “stagflation” was last experienced in the 1970s, the decade most often cited in today’s media frenzy about potential inflation doomsday scenarios looming on the horizon. In the 1970s, geopolitical events caused a sudden and unexpected disruption to the supply of oil, which sent prices sharply higher in a short period of time. In an economy that was already facing high unemployment, corporations could not pass these higher prices to consumers, and inflation contributed to the overall economic malaise.
Compare the stagflation of the 1970s with today’s environment. Broadly speaking, inflation pressure has been muted. Of course, investors’ concerns about inflation are not backward looking. With the Biden administration’s $1.9 trillion stimulus package and ongoing vaccinations creating a bridge to a fully reopened economy, investors are viewing inflation through the lens of what’s to come. In most market commentary regarding inflation fears, the logic goes something like this. Consumers, flush with inflated bank accounts from stimulus checks will unleash a purchasing frenzy that will lead to higher prices, i.e. inflation. But remember, even if this plays out, it’s not inherently bad. In this scenario, consumer demand would create higher inflation, which should lead to higher corporate sales growth and be a net benefit for the economy.
Others have pointed to the recent rise in some input costs as an omen for “stagflation” ahead. However, here again, consumer demand has been more than enough to offset rising input costs. Homebuilders are a great example of an industry that is prospering despite strong input cost inflation. Lumber prices have surged, yet homebuilder margins are expanding because of strong home sale pricing power and robust consumer demand.
The example of homebuilders reinforces the important “K-shaped” dynamic of the economic recovery. It has been our view since last year that the pandemic led to a “two-speed” recovery that created winners and losers with broad strokes across the economy. As this relates to inflation, there will certainly be companies that are unable to pass through higher input costs to consumers. However, these companies will be contained to certain pockets of the economy and broadly speaking there will be more “winners” than “losers” from a corporate perspective.