Inflation and what it means for investing is one of the biggest issues I have been hearing about recently. The topic can generate quite a bit of anxiety. But before we start to worry, let’s take some time to understand what actually happens when inflation hits the economy. Then we can panic—or not.
Advantages of Rising Prices
What is inflation? At its base, inflation is rising prices. From a company’s perspective, rising prices can be a good thing. Sales, after all, are prices times the number of widgets sold. If the number of widgets sold remains the same—a big if!—rising prices mean higher sales. In fact, many companies grow earnings just this way, by slowly raising prices over time. Revenue management is a dance between raising prices and maintaining demand, and inflation can actually make it easier to raise prices. If demand is strong, as it is right now, companies can raise prices—and sales—without hurting demand. And that is what we are seeing.
Rising Costs and Rising Earnings
Even if inflation means sales are increasing, it also means companies must deal with rising costs. But looking at the numbers, we can uncover advantages here as well. Other things being equal, if sales and costs increase by the same percentage, the company’s profit will increase because sales are larger than costs. For example, if sales are $100 and increase by 10 percent, sales will be up by $10. If expenses are $80 and go up by 10 percent, they will increase by $8. The total profit will increase by $2, from $20 to $22, on sales of $110 and expenses of $88. So, if expenses increase at the same rate as sales, profits can go up.
But, generally, expenses don’t increase at the same rate as sales. Some expenses do, of course, but costs like rent, supply contracts, wages, and equipment are typically contracted over one-year to multiyear periods. Because a significant part of a company’s costs are typically sticky, expenses will increase more slowly than revenues. Eventually, costs will catch up, but for a while the company’s revenues will go up faster than the expenses.
Increase in Margins
In addition to the profits bump discussed above, we can also see an increase in margins. To use a similar example, sales might go up by 10 percent over a year, or $10, and expenses might rise only by 5 percent, or $4. The profit would be $26 ($110–$84). As a stockholder, I am very happy to see both margins and profits increase—and could therefore bid up the stock, due largely to inflation. I am making these numbers up, of course, but the math holds. And the data so far suggests this scenario is exactly what is happening in the real world, thus partly explaining why the markets are so high.
Earnings Only Half the Story
Over time, though, the story isn’t that simple. Rising earnings are good for stocks, but earnings are only half the story. The other half is how much investors will pay for those earnings, expressed as a price-to-earnings (P/E) multiple. P/E multiples reflect how optimistic or pessimistic investors are, but they are also tied to interest rates. The higher the interest rates available, the less attractive stocks are relative to other options such as bonds—and the lower the multiple of earnings investors will pay. If inflation drives interest rates up, as it usually does, then the multiples for stocks may decline. So the market may decline even as earnings are increasing.
Interest Rates Bear Watching
As of right now, interest rates are up somewhat, but still within the range seen in recent years, and stock valuations are holding. Investors are reacting to better earnings but not to higher interest rates. So far, so good. But this fact highlights the need to pay attention to the effect of inflation on the market. It will not be inflation itself that sinks the market, but rather its effect on interest rates—and therefore P/E multiples. As an economist, I am watching the inflation rate. As an investor, I am watching interest rates. The two factors are linked but not identical. So far there is reason for caution—but not panic.
Nominal Vs. Real Dollars
There is another reason for caution. Given an environment of inflation, a company’s higher earnings may not be worth as much in terms of purchasing power—or, as the jargon goes, in real terms. That would be right. The real value of earnings does not increase nearly as much as the nominal numbers do. But earnings, costs, and stocks are priced in nominal dollars rather than real dollars, and nominal dollars include the effects of inflation. In other words, as earnings increase in nominal dollars, they will automatically include the effects of inflation plus the additional return gained as a company grows. So, over time, stocks can act as an inflation hedge, as company sales and earnings automatically include the effects of inflation itself.
Keep Calm and Carry On
That’s not to say there is nothing to worry about. The effects of a rise in interest rates could be material, especially in the short term. This potential is worth paying attention to. Over time, though, companies are well positioned to act on, and benefit from, moderate levels of inflation. Furthermore, even in the short term, with inflation where it is right now, we are still seeing relatively small movements in interest rates, suggesting rates are something to keep an eye on, but not worry about too much just yet.
Brad McMillan is the chief investment officer at Commonwealth Financial Network, the nation’s largest privately held Registered Investment Adviser-broker/dealer. He is the primary spokesperson for Commonwealth’s investment divisions. He is also the author of Crash-Test Investing, a must-read primer for Main Street investors seeking to help insulate their portfolios against a market crash. This post originally appeared on The Independent Market Observer, a daily blog authored by Brad McMillan. Forward-looking statements are based on our reasonable expectations and are not guaranteed. Diversification does not assure a profit or protect against loss in declining markets. There is no guarantee that any objective or goal will be achieved. All indices are unmanaged and investors cannot actually invest directly into an index. Unlike investments, indices do not incur management fees, charges, or expenses. Past performance is not indicative of future results.
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