Rising inflation? Keep calm and invest in equities

All signs point to rising inflation … so what?

The warning bells have sounded innumerable times over the past 40-plus years, but they have always been false alarms. That is, until now. Strong levels of demand, coupled with capacity constraints, are showing up in higher prices all along the production chain and into consumer prices.

Advisors would be well-served to recognize that inflation tends to run in long cycles. While this cycle may have finally reached an inflection point, ’70s-style runaway inflation is not right around the corner or even in the same area code.  

Nevertheless, the risk of higher inflation is clearly top of mind for investors these days. Over the past several weeks, the knee-jerk reaction has been to exit equities as inflation has ticked up. But that simple calculus, ingrained in psyches over the past decades — that higher inflation means lower stock prices — deserves scrutiny. If, as seems credible, inflation is finally taking hold, equities may be one of the safer, not riskier, options for investors.

Few would deny the economy is primed to run hot. Generous amounts of fiscal stimulus are sloshing around the economy. The Biden administration has teed up multiple trillion-dollar spending initiatives. Add to that a high level of savings, pent-up demand, ultra-low interest rates and a highly accommodative Fed and you have a wicked brew that conjures the ghost of Gerald Ford’s Whip Inflation Now campaign.

So we may be in store for several years of strong economic growth and steadily higher price levels. But again, so what?  This has happened before and many investors did just fine. From the end of the 1950s to the end of the 1960s, inflation advanced from the 0.50%-to-1.50% range to the 5% range. Equities generated solid real returns. 

The important question to ask is: If inflationary pressure is in our imminent future, as many suspect, what are the best options for advisers and their clients?
• Cash? Bad idea; those holding cash will lose purchasing power.
• Bonds? Even worse; at 2.5% yields, bond owners could lose both principal and purchasing power.
• Commodities or crypto currencies? Might be options but they are not without their own risks and drawbacks.
• Real estate? Prices are up a lot and property ownership can be tough to manage. Owning real estate through securities such as REITs might be a better option in an inflationary environment.

That leaves equities, which arguably could offer investors the best return even with rising inflation. Our view is that inflation is not bad for equities; it is good for equities. It is not inflation that is bad for stocks; it is the cure for inflation that is bad for stocks. Specifically, the policy restraint meant to shrink the economy in order to choke off inflation represents a challenge for equities. 

The risk of such policy restraint cannot be ruled out. The current administration could end up being fiscally conservative, with major tax increases paying for huge spending plans. But the path to more spending is much easier than the path to higher taxes.

Now that the administration has introduced the idea of tax hikes to pay for aggressive spending, they will always be able to say they cared about fiscal responsibility. It is not obvious what tools they have available and how much effort they are willing to make to translate that unpopular policy into reality, with the Senate split 50-50.  While the Federal Reserve may shift course as economic growth and price levels accelerate, Fed officials have been explicit in saying that is not on the table for 2021 or 2022.

We may be at the start of a multiyear expansion that will eventually lead into an overextended market top. Until then, it looks like equities may be the best place to find solid returns. 

[More: Market watchers say inflation risk is real]

Charles Lemonides is chief investment officer of ValueWorks.