Pt 3: Inflation: Why the monetary support comes with a hidden cost

The economic support provided globally by governments and central banks in response to the pandemic has been nothing short of extraordinary (in terms of scale, that is).

That’s because the scale at which shutdowns impacted global economic activity, in the form of business closures, event cancellations and travel restrictions, is one of the greatest endured during any global crisis.

While much of the support has been crucial in helping economies, businesses and people to transition through the abnormal conditions, there’s no such thing as a free lunch.

All of this support comes at a cost.

Some are direct costs, such as the fact that the fiscal support provided by most governments is from borrowed money (that they’ll have to eventually pay back), and others are more indirect costs.

We want to focus on these indirect costs because they can impact our portfolios in many different ways. By the end, we also want to outline what we as investors can do to make sure our portfolios and stocks within them are able to navigate these challenges.

For starters, it’s worth touching on the money supply. As a result of huge financial support over the last 18 months, many economies around the world have increased the amount of their respective currencies in circulation in order to stimulate their economies and encourage spending. The US is one of the best known and widely discussed examples of this.

The most commonly referenced figure for a gauge of a country’s money supply is called M2, and it is a combination of liquid monies like cash and short term bank accounts, plus savings accounts, longer term deposits, and money market funds.

This M2 figure reached $20.5 trillion dollars in July of 2021. To put that in perspective, back in January 2020, that figure was $15.4 trillion, meaning 25% of all USD in existence has been created in the last 18 months alone.

In a very simplistic way of looking at it and all else being equal, when you increase the supply of something, its value typically goes down since it isn’t as scarce as it was before. But in this case, the (nominal) value of a dollar is constant by definition, so when the money supply increases, a dollar buys fewer of the same goods and services now than it did a year ago.

What’s interesting is that we are already seeing signs of inflation, it just depends on the basket of goods you’re looking at.

If you’ve recently been to the grocery store, you might have noticed some items like meat and some produce are slightly more expensive. Whereas other more everyday items haven’t changed too much. That’s because unlike some meats and produce, most of those goods haven’t had the same sort of supply/demand shocks (discussed in Part 1).

However from what we’re seeing in the data, there are signs of above average inflation. Below is a chart showing the last 25 years worth of CPI (Consumer Price Index - explained below) data in the United States. You can see that from the lows of 2020, rates of annual inflation have been around 5% for the last few months, which is above the Federal Reserve’s goal of a 2% average rate (over the long term).

The CPI basket includes goods such as food and beverages, tobacco, gasoline, furniture, shelter, transportation, etc. The Federal Reserve is reportedly satisfied with this level of higher inflation at the moment because historically inflation has been below their 2% target for quite some time.
You may have heard the phrase “it’s transitory inflation” thrown around, and that simply refers to the fact the Federal Reserve believes this higher inflation is simply temporary, and will reduce to normal levels as supply and demand pressures normalise. Time will tell if this is the case...

Now, while those inflation figures above may not appear to be too high (though some claim the inflation figures are actually understated, it hasn’t been as high as what we’ve seen occur in other asset classes. That’s why it’s useful to look at both CPI data, and asset price data.

A cocktail of huge increases in the money supply, ultra low interest rates, limited supply and higher than usual demand have helped drive the prices of other more scarce asset classes upwards.

Whether it be equity markets, real estate, some commodities or cryptocurrencies, many asset classes outside of the CPI basket of goods have experienced much higher “inflation” over the past 18 months.

For example, if you look at the average price of a home in the US, it has risen to a high of $363,000 in June this year, up 23% from 12 months prior (now back at $356k). Plenty of other real estate markets around the world have experienced similar price appreciation.

If you look at the US stock market (S&P 500), it has risen 35% in the last 12 months alone, and is up 92% from the lows during March 2020. We can see from the SWS chart below, that from January 1st 2020, the increase in market capitalization (roughly 50%) appears to be slightly outpacing underlying earnings growth (roughly 23%).

That either means that investors have higher expectations for the future earnings growth, OR they’re allocating their funds to the asset class of “equities” simply because it is perceived to have a better risk/reward profile than other asset classes, like cash or bonds.

This second possibility stems from the idea of opportunity cost, that is, an investor’s decision of where is best to allocate their personal funds.

It’s clear that while we might not be seeing as much inflation in the CPI basket of goods (at least not yet), we are certainly seeing it in other areas and asset classes.

If the money printing is set to continue, then it appears that the opportunity cost of holding a non-scarce asset like cash over more scarce assets like equities, becomes even more clear.

You may have heard the saying “Cash is trash”, and that’s simply referring to the fact that in the current financial system, it doesn’t have the best track record of performance.

To stress that point, $1 USD back in 1913 had the same purchasing power as $26 in 2020. Most fiat currencies around the world (money issued by central banks or governments) have followed a similar trajectory, or worse.

Figure 4: Purchasing Power of the US Dollar from 1913 to 2020 - Created by Visual Capitalist - April 2021

Now just to be clear, we’re not saying holding cash over short periods of time is bad. In fact it’s great to always have some cash on the sidelines, because it allows you to deploy funds during rare opportunities when assets go on sale. (This is referring to cash for your investments which is separate to cash for an emergency fund).

If you held cash over the long term though, historically speaking it’s been a horrible investment. It’s slowly deteriorated in value thanks to the invisible hand of inflation as the money supply has grown.

So as mentioned, if the trend of money printing is set to continue long term, then allocating funds to scarcer assets (like equities) rather than holding cash seems like the better alternative.

If we do then decide to allocate our capital to stocks, this then raises some follow-on questions:What stocks should we buy? How can we assess their strength? Do they have any weaknesses? What are their future prospects like? Will they be able to handle an inflationary environment?

You might know that our philosophy at Simply Wall St is to not try to predict where the market is going or what will happen next in the macro environment. Instead we’d do well to continue following some core investment principles that have stood the test of time. One of them is:

Buy high-quality businesses with good long term prospects at a price below their intrinsic value.

Here’s some questions, a checklist of sorts, that can be useful to ask ourselves when looking at a stock (and how Simply Wall St can help in some areas):

1. Is the company a high-quality business that generates high returns on capital?

“Quality” businesses are those that have a sustainable competitive advantage over their competitors. Think of things like brand power (Apple NASDAQ:AAPL), economies of scale (Costco - NASDAQ:COST), or network effects (Facebook - NASDAQ:FB).

In terms of determining the company’s return on capital (how much it makes per dollar invested), you can check out the Simply Wall St Past Performance section within each company’s report to see how well the company allocates money. Here’s an example of Apple’s returns.

2. Does the company have good future prospects?

As mentioned in Part 2, it’s much easier to invest in industries with tailwinds rather than headwinds. If the company has good growth prospects with more room left in its Total Addressable Market (TAM) to serve, then it’s got room to grow. On Simply Wall St you can check out the Future Growth section, here’s Amazon (NASDAQ:AMZN) for example.

3. Is the business capital intensive?

If the business requires a lot of upfront capital invested to generate its product or service (think manufacturing or construction), then it can be vulnerable to inflation pressures if the cost of its inputs increase. However if it’s a capital light business model (think software), then it’s less vulnerable to having its margins eaten away by inflation (that is if its costs increase but it can’t increase its prices equally). Here again, for example, we can see Apple’s operating expenses remaining flat while revenues have increased, which have helped drive profit margins higher.

4. Can the business raise its prices at or above the rate of inflation?

Think about it this way, does the business provide enough value to customers where they are happy to pay up if prices increase? Or would they go to the cheaper alternatives? Is the business in a market where consumers are simply looking for the cheapest product, or does the company have a business or status where it can afford to raise its prices and not lose any customers?

5. Is the business able to afford its debt? (if it has any)

Given the current low interest rate and inflationary environment, taking on debt is actually quite an appealing source of capital. So utilizing debt effectively can help a company increase its profitability. The key here is to assess if the debt is affordable, especially if interest rates were to rise. Within the Financial Health section, we run checks on the affordability and absolute level of debt, so you can get a quick understanding of both how leveraged a company is, and how affordable that debt is.

6. Is the business in a growing industry?

As mentioned before, investing with tailwinds is easier than investing in an industry facing headwinds. You may know of industries that are growing and that you want to invest in, but not be aware of the particular companies within it. We’ve got a screener to help with that.

If you want to look at the Renewable energy sector for example, which we know is growing, you can start by checking out the Global Renewable energy screener we’ve developed, then drilling down from there depending on what country you want to look at.

7. Is the company trading at a discount or premium to its intrinsic value?

We could do a whole email series on the nuances of valuation, so we won’t go into depth here but just keep this in mind. A high quality business can become a bad investment if you pay too much.

If now isn’t the right time to buy, be patient. If the company still ticks all the other boxes for you, it’s worth putting it on your Watchlist within SWS because the market can fluctuate and give you an opportunity to buy at a better price. From there, you can monitor all its developments, set your own fair value and we’ll keep you up to date on all the important updates.

This list is by no means all-encompassing, but by simply following this short checklist and other timeless investment principles (which we’ve covered in our 3-part election series last year), we can position ourselves to:

  1. Better withstand whatever macro-environment we face
  2. Make more informed investment decisions
  3. Avoid succumbing to FOMO
  4. Be confident in the portfolio of high-quality stocks that we own
  5. Take advantage of structural growth opportunities
  6. Not overpay for businesses, no matter how good they are

So that brings us to the end of our 3-part series! We’ve covered 3 global issues that are causing structural multi-year changes and how to navigate or take advantage of them, with some help from the Simply Wall St platform.

We hope you’ve enjoyed this series and got some value out of the content covered!

Invest Well,

Michael Paige

Simply Wall St