The big difference between bonds and equities is that cash flows in bonds are fixed in advance. It makes inflation the great enemy of bonds. With equities, the effect of inflation is more complex. Companies that raise prices often realise higher sales as a result. But with a lag, inflation, in the form of rising wages and rising interest rates, creates margin pressure, as do rising energy prices.
Debt-free companies with relatively few staff and low energy consumption are then at an advantage. There, profits also rise with inflation. However, the risk of high inflation is that too much of the profit is returned to shareholders, leaving insufficient to invest, resulting in slowing profit development over time.
Key question: what causes inflation
For the impact of inflation on corporate earnings, it matters what causes inflation. While supply problems suggest that problems have arisen on the supply side, that is only half the story. That is true insofar as the pandemic and lockdowns caused a shift from the services side of the economy to products largely made in China. Demand for products from China was driven by ample liquidity from central banks and governments.
In a short time, the money supply in the United States rose by 30 per cent. Not surprisingly, not long after, exports from China also rose by 30 per cent. Nor is it surprising that such explosive growth leads to supply problems. On this point, there is now a big difference between the United States and Europe.
In the United States, inflation is still largely driven by the demand side of the economy. In Europe, it is almost exclusively the supply side and mainly in the form of high gas and electricity prices. The difference in corporate earnings is that strong demand in the US increases sales, while high energy prices in Europe reduce sales. And that makes quite a difference in the final result.
Inflation is still rising, while supply problems are actually decreasing. Other costs such as wages, interest and energy are also not yet causing an explosion on the cost side. Wage growth is partly offset by productivity development. Now, on paper, this productivity development does not want to go smoothly, although it is not so easy to measure productivity these days.
Lure of automation
Anyone looking around sees productivity everywhere except in the numbers. High wages and lack of human resources are driving investment to automate things. Just think of ordering a drink through a QR code. Interest and energy are largely tied up in long-term contracts. Many companies have taken advantage of low interest rates by financing themselves longer. US companies benefit additionally through strong sales growth in hard dollars, while that same strong dollar now allows those companies to buy cheaply. In Europe, the reverse is true.
Prices are rising across a broad front. It is not that at all those companies, costs have also risen at a rapid pace. Companies raise prices because they can. If 9 products in the supermarket become more expensive, the price increase at the 10th product is no longer noticeable. Furthermore, entrepreneurs have been seeing the recession coming since the beginning of this year. After all, that is what central banks seem to be steering for. A businessman who sees a recession coming tends to make hefty cost cuts in advance.
Do not underestimate positive effects
Even Elon Musk therefore wanted to lay off 10 per cent of staff earlier this year. Now, the coming recession is the most predicted recession ever. Surely, then, it would be strange for companies not to have taken measures. Further, the stock market cannot price in a recession twice. Many people see the stock market falling another 20 per cent because corporate profits will come off. Given the inflation effect, this is not too bad for now. However, what people forget is that in the last eight recessions in the United States, 10-year interest rates have fallen by an average of 3 percentage points.
Now, a drop from 4 per cent to 1 per cent may seem like wishful thinking, but realise that closer to zero, the effect of interest rates on valuations increases. If interest rates fall from 6 per cent to 3 per cent, that is a halving, as is a fall from 4 per cent to 2 per cent. The positive effect on the relative valuation of equities is the same. It is possible that profits will fall in the coming recession, but that is likely to be more than offset by falling interest rates. In the meantime, do not underestimate the positive effect of inflation on earnings.
Han Dieperink is chief investment strategist at Auréus Asset Management. Earlier in his career, he was chief investment officer at Rabobank and Schretlen & Co. He is one of Investment Officer’s knowledge experts. His contributions to Investment Officer Luxembourg appear on Thursdays.
This article originally was published in Dutch on InvestmentOfficer.nl.