Why the past doesn’t hold the key to inflation protection

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June 2022
 
With inflation rearing its ugly head once again, investors may feel inclined to look to the past for clues to handle market volatility. But, as Newton US Equity Income portfolio manager John Bailer notes, the last 10 years is probably not going to be like the next 10.

While the past may help inform predictions, challenging macroeconomic conditions are increasing inflationary pressures, making it futile to compare now with the past as a guide to the future, says Newton and US Equity Income portfolio manager John Bailer.

According to Bailer, one of the main differences between today and the past is the way debt is viewed. After the global financial crisis, banks were overly leveraged and therefore needed to rebuild capital, which led to a decade of low growth, Bailer says. Without the need to recapitalize, Bailer says growth should start to return to normal levels.

“Now the banks are well capitalized, it is very different to the beginning of the past decade, and that is one area where we think the markets got it wrong when thinking about lower for longer interest rates and inflation being moderate for the next 10 years,” he says.

Fiscal policy in the US has changed, too, says Bailer. “Ten years ago, it was all about austerity in the US. That isn’t the case any longer,” he adds. “The US is starting to spend a lot more money from a fiscal perspective. That started with President Trump and is continued with President Biden and the Democrats, and I think that’s going to continue.”

For example, Bailer notes there has been discussion around states and federal governments cutting taxes on gasoline.1 While consumers may feel some relief at the pump with this measure, it doesn’t do anything to reduce demand – and a strong demand exaggerates inflationary pressures, says Bailer. “You keep demand high when you subsidize things and that is what the government is doing today.”

Deglobalization is another inflationary trend shaping the future, he says. After spending decades trying to lower costs by outsourcing production, there is a shift to manufacture goods nationally, a lot of which has to do with technology security and cyber threats. “We do not want our technology to be sourced from Taiwan or from China,” Bailer says. “You want the least amount of cyber threats so you need to produce the semiconductors in the US.”

Bailer thinks there will be a “manufacturing renaissance” in the US but points out this will likely result in higher costs and thus more inflation.

Rising wages is another factor to keep in mind, he adds. Nowadays, employees have the upper hand and can command higher salaries as businesses compete to obtain and retain talent.2 This situation is the opposite of the last financial crisis when many people were losing their jobs and struggling to find employment.3

Elsewhere, Bailer says commodities demand is likely to remain elevated, especially for diesel and jet fuel, for example, as people start to travel more. “The supply-demand dynamic within the energy space is here to stay and will lead to higher prices,” he adds.

Outperforming during inflation

Bailer says the effects of inflation may be hard to avoid, but there are stocks that may likely perform well as interest rates edge upwards and valuation spreads have widened. “Over the last 100 years the cheapest quintile of value stocks has outperformed the most expensive quintile by 426 basis points.4 So, value works over time, especially in inflationary environments,” Bailer says.

He adds what may be considered the real darling in an inflationary environment is dividend stocks. “Dividend growth and high dividend stocks outperform in low and high inflationary periods, but they do particularly well in periods of higher inflation.”

That being said, investors shouldn’t expect to see immediate growth as it takes time for rate hikes to impact the economy. "We expect the dividend yield factor in a slowing economy is going to be efficacious,” Bailer concludes.

1 New York Times. Some states suspend their gas taxes, looking to ease pain at the pump. March 27, 2022

2 NPR. The US jobs market continues its strong comeback from the pandemic. May 6, 2022.

3 U.S. Bureau of Labor Statistics. The Recession of 2007-2009. February 2012.

4 Source: Alliance Bernstein, as of February 2022. Taken from the Ken French database (Fama-French models of US listed securities). The Fama-French Price/Book value weighted series – Value/Growth 10 year annualized rolling relative returns.

 

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