What if inflation takes off – stocks or property?- Pete Wargent

I noted the other day that we are living through a period of low interest rates, and in some countries at least, relatively low inflation.

Let’s have some fun today considering what might happen if inflation takes off, and how that might impact investors.

Stocks

Conventional wisdom says that stocks are a good hedge against inflation, since the investor continues to own a part claim on the assets of the company, and over the long term this may indeed be true if you are owning shares in outstanding companies.

There is no escaping however, that a jump in inflation can eat away at the dollar value of dividends.

Buffett would always say you should try thinking of stocks in the same way as you would a bond: you buy the investment to receive a “coupon” (dividends), but you also hope that a quality company will increase its earnings and therefore market capitalisation or valuation over time.

Even though that “coupon” from the company is not fixed since company earnings tend to gyrate, over time the returns on equity in the market may be more consistent than you might expect.

Of course, stocks are quite different from bonds in lots of ways.

For one, thing companies and stocks are perpetual while bonds eventually fall due and can be renegotiated, and thus stockholders are kind of stuck with corporate returns. In that sense, stocks are considered to be riskier.

There are other differences too, in particular the vast swathes of traders and speculators in the stock markets who, in aggregate, don’t achieve a great deal except for making brokers happy through transaction costs.

Can companies increase returns in times of higher inflation?

Well, let’s think about it logically. If I remember what I learned accountancy college correctly (by no means a given) there are basically five ways in which companies can increase their returns, those being:

1 – Boosting the turnover ratio?

Turnover may increase with inflation, but can it increase in relation to the assets employed by the business?

Hmm, not so sure about that.

Receivables (what we used to call debtors), for example, just tend to increase in proportion to sales.

I suppose turnover could increase over the short term in relation to the company’s fixed asset base if the assets are being replaced slowly, but the impact of this is likely to be muted, and over the long term companies will probably have to replace their property, plant and equipment at higher prices anyway.

As for turnover in relation to stocks or inventories, this relationship can tend to jump around a bit depending on what’s actually happening in the business, such as supply bottlenecks and so on.

Over the decades the beancounters have used accounting trickery such as last in first out accounting (LIFO) to reduce corporate earnings and therefore tax payments. But over time, there is unlikely to be much of an improvement here either.

So, what about…

2 – Improving profit margins?

If you’re an optimist you might argue that in times of inflation companies can improve margins by simply increasing sales prices ahead of costs. [sam id=40 codes=’true’]

Yeah, well…maybe.

Ultimately, though, there are only 100 cents in the sales dollar, and company costs – which include the cost of sales or raw materials, staff wages, utility bills or energy costs, and admin expenses – are most likely heading north too.

Moving down the income statement…

3 – Cheaper debt or leverage?

Lower interest expenses might improve returns? Pretty unlikely. If inflation goes up, interest rates probably will too.

Racing inflation tends to cause companies to require stacks of capital to keep a business galloping along, but lenders tend to become less trusting in long-term borrowings and thus the cost of debt will more likely be higher.

4 – Using more leverage?

A possible option, but more leverage tends to equivalently increase company-specific risk, and lower credit ratings can also see the cost of debt increase.

5 – Lower corporation taxes?

Well, we live in hope. Never say never, but I wouldn’t bank on it.

The problem with stocks and inflation

Considering all of the above, it seems likely that higher inflation may not necessarily afford companies the opportunity to increase corporate returns, and this can present a bit of a problem.

If a company makes a return of, say, 10%, pays out 5% as a dividend (effectively taxed by inflation as well as income taxes in the hands of the investor) and 5% is reinvested in the business in times of higher costs…the impact of higher inflation now seems less than rosy for the world of stocks.

In any case, this is all working on the basic assumption that you are buying shares at the equivalent of book value, which in most markets is not possible, so this is a consideration for future shareholder returns too.

Over-arching all of this is that if inflation spikes then interest rates will likely also increase, and the perceived higher risk of shares is likely to see investors bombing for the exits in order to seek safer returns from bonds or fixed interest investments (which would now be generating more attractive returns due to the higher interest rates).

Of course, in aggregate, investors can’t all exit the stock market at once, so the likely result is transaction costs as investors turn over their portfolios more frenetically, and much lower stock valuations all round.

This is why the best bet for most average investors can often be to try to think as stocks as being more like a bond, and continue to receive those increasing “coupons” (dividends) over time, worrying less about trying to jump in and out of the market ahead of the herd.

Real estate as an inflation hedge?

Conventional wisdom also tells us that property is a great hedge against inflation.

It’s true that inflation reduces the value of mortgage debt. What is inflation, after all, if a transfer of wealth from creditors to borrowers?

And, over time, inflation might see wages increase which can eventually push property prices higher.

All very neat, and a win-win for property then?

Well, maybe, but it’s not really that simple at all.

As noted before, if inflation goes up, then so too will interest rates, and this may impact property prices adversely due to reduced demand, particularly where real estate valuations are already considered to be high.

And, of course, when you eventually come to liquidate your investment, you’ll find that the cost of living is much more expensive thanks to the silent thief of inflation.

This, incidentally, is why many investors in remote locations don’t experience the level of success that they might feel they have: if the rate of property appreciation doesn’t beat the inflation rate, then the returns will necessarily be stunted.

In fact, if you start playing around with a few numbers in a model which variously considers possible rates of inflation, interest rates and expected capital growth outcomes (I wrote a short piece about this topic here), you’ll often find that the internal rate of return (IRR) on property as an investment doesn’t change very much at all, regardless of what the inflation rate is doing.

In summary, higher inflation would surely inflate away the value of debt, but you’ll likely be clobbered with higher interest rates, and your money will be worth less when you liquidate.

The implication of this, then, is that the specific choice of asset is vital in determining returns.

Simply put, you need to find a property investment which increases in value (or price) ahead of the inflation rate if you want to get ahead.

Summary

It’s far from all bad news, however.

Just flicking back through what I’ve covered above, it seems to me that most investors in shares and property should probably hope for a bit of inflation, but not too much. Moderation is best.

The good news is that over the past two decades the Reserve Bank has introduced an inflation target and has largely been achieving this with the odd blip, and interest rates have not been very high for a couple of decades either.

So, try to remember all this when the first interest rate hike inevitably comes.

Rather than groaning, remember that the RBA targets inflation and price stability for a good reason, and one which ultimately is for our own good!

[post_ender]



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Pete Wargent

About

Pete Wargent is a Chartered Accountant, Chartered Secretary and has a Financial Planning Diploma. He’s achieved financial freedom at the age of 33 - as detailed in his book ‘Get a Financial Grip – A Simple Plan for Financial Freedom’. Pete now manages his investment portfolio, travels and works as a consultant in the finance industry from time to time. Visit his blog


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