A significant risk to global equity markets on the horizon is inflation. The latest round of stimulus has elevated global debt to GDP ratios to unsustainably high levels. Since countries will never be able to pay down this debt, one way out of this problem, is for central bankers to inflate the value of the debt away. In such a scenario, there will still likely be negative real interest rates, but nominal interest rates, which include inflation, will rise. This would be good for Value stocks and it is important to understand why.
The price of a listed company is the discounted present value of its future cash flows. Investors discount the company’s future cash flows because, typically, a dollar received in the future is worth less than a dollar today. The rate investors use to discount these future cash flows is based on the risk of losing their investment capital as well as the loss of purchasing power due to inflation. Currently, there is little incentive to use high discount rates, because deemed risks are low – opportunity costs of investing elsewhere are low (cash deposits at global banks are earning near 0%) and there is no inflation on the horizon (no loss of purchasing power over time).
Investors can, therefore, pay high multiples (ex. high price to earnings ratios) for a company because they can afford to wait a very long time to get their money back. They don’t have to be concerned about earning a good yield (earnings yield or dividend yield) in the meantime to compensate them for the risks involved in holding an investment position.
However, if inflation is on the horizon, the inflationary risk to their investment capital will become a concern. The likely effect will be that investors will use higher discount rates to discount the future cash flows of their investee companies, which will reduce their investment values today (i.e lower share prices). Share prices of companies trading on very high multiples (ex. 50 price to earnings ratios and more), which tend to fall in the Growth camp of investment styles, will likely be more negatively impacted than companies trading on very low multiples and paying a good dividend, which are characteristics of Value type companies. The latter type of companies are, in essence, already compensating investors for future risks. They should, therefore, be sold down less in an inflationary scenario.
There are two major indications that inflation can occur going forward. Massive monetary stimulus flowing directly to the banking sector, driving price inflation (demand-pull inflation) and a decline in globalised manufacturing networks, driving up the cost of products (cost-push inflation).
We don’t know how long it may take for inflation to be factored into investor valuation models. However, in order to manage the risk of its occurrence, it is important to maintain a blended portfolio across investment styles as well as asset classes.
Fintax Group is an authorised financial services provider (FSP642).