Inflation Insulation: Navigating the Nuances of Inflationary and Rising-Rate Environments

Moderate inflation can be good, especially for some value stocks. Christian Correa breaks down why investors should not be afraid of the current inflationary or rising rate environments and explains how they can actually help some businesses and areas of the equity market.

Moderate inflation can be good, especially for some value stocks. Yet, the word “inflation” strikes fear into the hearts of many investors. Those who are old enough to remember might think about the United States in the 1970s or Brazil and the former Yugoslavia in the early 1990s. Today’s environment is very different. We believe we are in a period of transitory price increases which will last months, not persistent high inflation lasting years. We think current cost-push inflation is poised to give way to a healthy, regenerative demand-pull environment, replete with moderate economic growth that is beneficial for the value companies in which we invest.

Under Pressure

History has shown moderate inflation can be good for value stocks, as illustrated in the chart below. We consider “moderate” to be between 2% and 4%. Compared to historically low inflation rates since the global financial crisis (GFC) over a decade ago, this may feel like a shock. However, modest demand-pull inflation is healthy and normal. Demand-pull inflation occurs when increased consumer demand for products allows companies to raise prices. This usually coincides with a period of moderate economic growth, as consumer demand makes up about 70% of US gross domestic product (GDP). When consumers and businesses consume more, the economy grows. This creates a favorable environment for many value companies.

The pandemic has caused cost-push inflation. The cost of inputs has gone up due to component and labor shortages. Investing in businesses that can absorb these price increases or pass them along to their customers in the form of higher prices without it affecting their market share is the first line of defense in a cost-push environment. In our experience, companies with strong brand names or whose products are in high demand and have few substitutes can achieve this. These companies may also benefit when the inflationary environment abates, as they can continue to charge a higher price for their product, leading to margin expansion which may lift the stock price.

Companies with low pricing power, such as companies with fixed-price contracts or those which do not have a powerful brand name behind them, might struggle to raise prices when their cost of materials increases. This leads to margin erosion and can weaken the financial standing of the company, reducing the stock price. This intricate understanding of a company, its place in the market, and the effect of inflation on its business can only be gained by in-depth fundamental research performed by an industry expert.