Investing in Times of Inflation

Long term investment strategies involve identifying investments that prioritise quality to successfully secure financial objectives when investing in times of inflation.

The Historical Context: Low Inflation and Robust Returns

From 1980 to 2020, a period characterised by declining global inflation and interest rates, corporate returns on equity (RoE) consistently outpaced prevailing interest rates. This era proved bountiful for stock investors, and particularly bond (or bond-like) investments — secured during periods of higher rates — generated unprecedented profits as interest rates declined.

During this cycle of decreasing interest rates, equity investors capitalised on the reinvestment of retained corporate profits, reaping the rewards of the companies in which they invested. As these firms navigated their growth, the wisdom of reinvesting profits became increasingly apparent.

Unlike bond investors, who could only reinvest at generally lower rates as bonds matured and contracts were renegotiated, equity investors enjoyed the advantage of reinvesting retained corporate profits into whatever returns the company was generating. This dynamic allowed investors in equities to benefit from the compounding effect of reinvested earnings, enhancing their overall returns in a fluctuating market.

However, the benefits of the past are now replaced by the realities of inflation and higher rates, which demand new strategies for success.

The Rising Tide of Interest Rates

However, the landscape has shifted dramatically. Rising interest rates in response to higher inflation have led to a decline in the value of pre-existing fixed-interest investments. In this inflationary environment, real returns can turn negative, which is particularly concerning for outsourced private and public pension funds that must comply with statutory requirements to hold a high proportion of fixed-income securities. The potential for increased funding gaps highlights the fragility of pension plans under such economic pressures.

This situation also creates a challenging environment for corporate finance, where rising costs of production and debt can strain profitability and complicate effective capital management. This requires a nuanced approach to capital raising.

While one might hope that businesses could maintain price levels based on replacement costs during inflationary periods, the reality is more complex. Despite a widespread belief in their market power, many large companies struggle to implement effective increases in profitability.

…at the source, peacetime inflation is a political problem, not an economic problem. Human behaviour, not monetary behaviour, is the key.

– Warren Buffett, Investor and former CEO – Berkshire Hathaway

This perspective underscores the deeper intricacies of inflation and its broader implications. Investing in times of inflation requires more than armchair analysis of short and medium term trends.

Adapting Strategies in an Inflationary Environment

What’s New? In light of these evolving dynamics, a cautious approach to bond acquisitions and similar fixed-income assets, such as real estate ventures, has become prudent. This strategy arises from the belief that the low inflation and interest rate environment of recent decades is unsustainable. This caution has extended even to equities, especially following the surge in public market equity valuations.

Low rates and increased leverage drove short-term returns: Market prices of equities have structurally moved higher than book values, especially so in the period 2019-2024, buoyed by low interest rates and exceptionally high Returns on Equity (RoE). This is particularly the case in the United States, where increased debt leverage and share buy-backs played significant roles in share price movement.

What to do? Despite impressive nominal RoE performances between 2007 to 2021, more lately real returns, when adjusted for inflation, reveal that returns of 2022 and 2023 were significantly lower than historical averages. A critical focus on real returns has become increasingly important when making inflation investments. Investors should now adopt a more cautious approach to bonds and fixed-income assets in light of the changing economic dynamics.

The Decline in Profitability

A key driver of caution regarding equities is the decline in profitability. Rising interest rates increase debt costs, squeezing corporate profitability. If interest rates remain high, a prolonged period of lower profitability is likely.

In 2022, the S&P 500 index experienced a nearly 20% decline, a year marked by unfavourable conditions for both stocks and bonds. For a family office managing a one-billion-dollar investment portfolio, a $200 million paper loss could be alarming. For a fully invested portfolio of $5 billion, paper losses approached $1 billion, prompting a heightened desire to exit equities in favour of perceived safer hedges against inflation. But this would be a mistake.

Considering the Duration of Inflationary Impacts

The low deposit rates offered by retail banks render cash holdings unattractive, while government bond rates remain mostly negative or marginally positive. This situation is unlikely to change unless there is a substantial decline in inflation. Signals from the US Federal Reserve indicating a peak in inflationary expectations may be partially offset by increased wage settlements, contributing to ongoing inflationary pressures.

To assess whether we are emerging from—or the potential duration of—an inflationary period, it is essential to analyse the underlying causes of inflation. While cyclical recoveries following COVID-19 and global supply chain constraints initially contributed to rising inflation, larger monetary and fiscal drivers, as well as geopolitical reactions to Russia’s invasion of Ukraine and the liberalisation of gas pricing in Europe, play a significant role.

The impact is not only on energy pricing, but also on manufacturing of chemicals, given raw material inputs. Cost pressures will severely impact returns when investing in times of inflation.

Structural Challenges Persist

The rapid growth in money supply — 25% of all US dollars ever created in recent years — coupled with substantial fiscal stimulus, has been a major contributor to rising inflation. The Federal Reserve’s $2.5 trillion in private sector debt purchases at market highs, combined with the recovery from COVID-related shutdowns and stimulus initiatives aimed at funding a global energy transition, further exacerbates inflationary pressures.

Future inflationary risks are multifaceted, stemming from ongoing growth in public and private sector credit, stimulative fiscal policies for potentially costly solutions in the energy transition, and shifts in global trade flows back to traditional powers. These dynamics are further complicated by the liberalisation of the European gas market and a geopolitical drive for energy security.

A Changing Energy Landscape

The transition in European hydrocarbon gas pricing, moving from long-term piped contracts to importing liquefied natural gas (LNG) via a system based on the virtual Dutch TTF (Title Transfer Facility), is a fundamental shift driven by the geopolitical response to the Russian invasion of Ukraine. This realignment, characterised by price determination through smaller flows, has created elevated risks of long-term energy price inflation.

Countries that import energy and petroleum products, especially emerging economies in Africa and Asia that also rely on raw materials from Ukraine or Russia, have been severely affected by the ongoing conflict and retaliatory policies. Many of these nations, already grappling with COVID-related debt, now face additional strains from inflated energy markets.

Given the global response to Russia’s invasion, it is surprising that there hasn’t been stronger condemnation (even sanction) of specific OPEC nations advocating for cuts in oil supply quotas. This scenario raises questions about our collective responses to opportunism amidst crisis.

Right, as the world goes, is only a question between equals in power, while the strong do what they can and the weak suffer what they must.

– Thucydides, The Peloponnesian War, Book 5, chapter 89

The Consequences of Currency Depreciation

Rising imported inflation and growing US dollar-denominated debt burdens have undermined the balance of payments and currencies in emerging markets, compounding inflationary pressures. To counter these challenges, many countries have turned to increased domestic currency lending (as opposed to US dollar-based lending) to address balance of payments issues.

Periods of high inflation not only erode real returns through currency depreciation but also provoke political responses, particularly heightened rhetoric around alliances, energy, and military security. This often results in higher-cost insourcing strategies, further fuelling inflationary pressures. These developments underscore the need for vigilance as shifting traditional power dynamics continue to reshape the global geopolitical landscape.

The Implications of Rewiring the Global Economic system

The interconnected global economy that emerged post-World War II aimed to enhance efficiency, resource sharing, and international collaboration. Leading the charge, the United States not only spearheaded economic reforms but also set the tone for ethical business practices on the world stage.

A notable example of this leadership occurred under Ronald Reagan, when the U.S. initiated global conservation efforts to “Save the Whales” and enforced stringent policies to prevent other nations from engaging in harmful activities. This approach illustrated how economic power could be wielded decisively to uphold environmental and ethical responsibilities, rather than relying solely on voluntary cooperation or a narrow focus on profit maximisation.

However, the rise of anti-globalist sentiments, fuelled by extreme nationalism, threatens to lead to isolationist extremes and powerful alliances that perpetuate global inequalities, potentially fostering international conflicts. Rising global tensions, energy insecurities, and shifts in global alliances all feed into inflationary pressures, making investment more volatile.

Geopolitical tensions

The re-shoring of production and the adoption of industrial policies, initiated during President Obama’s administration and intensified under Presidents Trump and Biden, are expected to accelerate further due to stimulus initiatives like the US Inflation Reduction Act. This trend persists despite G20 commitments made after the Global Financial Crisis to avoid launching competitive industrial policies. Similar initiatives are also emerging in Europe through the European Green Deal Industrial Plan and in policy measures in China.

In China, where state-owned enterprises (SOEs) are collectively owned, a portion of state spending is specifically aimed at improving the returns and competitiveness of these companies. This spending can be compared to capital expenditure by private companies in the West, as both seek to drive growth and enhance productivity. While this structure of state ownership may seem unfair, it is also viewed unfavourably in the West and will continue to be labeled as protectionist, inviting retaliatory industrial policy actions.

These structural changes in global trade and production flows may lead to additional supply shocks, reinforcing sustained inflationary pressures and the risk of persistently high interest rates. Navigating this landscape requires nuanced strategies that recognize the benefits of self-sufficiency alongside the necessity of collaborative efforts to tackle global challenges.

Regrettably, the momentum of populist movements often gravitates toward simplified narratives that prioritise energy security, militarisation, protectionist trade policies, and stricter immigration measures. This trajectory poses significant challenges and potential turbulence for the future.

Our principles offer no hard and fast line how far it is appropriate to use government to accomplish jointly what it is difficult or impossible for us to accomplish through strictly voluntary exchange.

– Milton Friedmand and Rose Friedman – Free to Choose – 1980

Strategies for Enhancing Profitability Amid Inflation

In light of the challenges when investing in times of inflation, there are five strategies that companies can adopt to improve profitability to navigate inflationary pressures:

• Increase Pricing Power: Companies should strive to strengthen their ability to raise prices without significantly impacting demand. This can be achieved through product differentiation, brand loyalty, and improving the value proposition.
• Enhance Operating Efficiency: Streamlining operations to reduce costs can improve margins. This involves evaluating processes, eliminating waste, and investing in technology that increases productivity.
• Focus on High-Quality Earnings: Prioritise sustainable earnings over short-term gains. This means investing in core competencies and avoiding risky ventures that may offer quick returns but jeopardise long-term stability.
• Consider Financial Resilience: Maintain a strong balance sheet to withstand economic downturns. This includes managing debt levels effectively and ensuring adequate liquidity to navigate inflationary environments.
• Leverage Strategic Investments: Invest in assets that can outpace inflation, such as real estate, commodities, or inflation-linked securities. Diversification across various asset classes can help mitigate risks associated with inflation.

However, improving returns are not easy. Moreover, just because a company earns 8% on equity invested in plant and equipment doesn’t mean shareholders will see the same return. New investors entering at market value—often much higher than the initial equity—may face lower returns, especially compared to safer investments like bonds in overvalued equity markets.

In addition, highly leveraged companies, where plant and equipment have been financed with debt, face even greater challenges. Even with low interest rates, such as 5%, a large portion of earnings goes to servicing debt. In these cases, increased sales might only mean faster loan repayment, with equity appreciating in value only if earnings exceed the interest costs.

Investors must carefully assess their risk and potential returns when investing in times of inflation.

Identifying companies with effective pricing power and robust balance sheets is exactly the type of analysis we provide in our Sponsored Equity Research. These reports help investors distinguish between companies that can weather inflationary pressures and those that cannot.

Inflation’s Impact on Investments

Inflation affects various investment classes differently, creating both challenges and opportunities for investors. Understanding how inflation impacts fixed-income, equities, real estate, commodities, and cash holdings is crucial for investors looking to protect their portfolios and maintain purchasing power over time.

• Fixed-income Investments: Inflation significantly challenges fixed-income investments like bonds and fixed deposits. Since these investments offer fixed interest rates, rising inflation reduces the real value of returns, eroding the purchasing power of investors who rely on this asset class.
• Equities and Real Estate: While not immune to inflation, equities and real estate have historically outpaced inflation over the long term. Companies with strong pricing power can pass rising costs to consumers, maintaining profitability. Real estate investments often benefit from rising property values during inflationary periods, but investors must also consider inflation’s impact on specific industries and sectors.
• Commodities and Inflation Hedges: Certain commodities, particularly gold and precious metals, are considered reliable inflation hedges. Their demand tends to increase during inflationary periods as investors seek to protect their wealth. Inflation-linked bonds and Treasury Inflation-Protected Securities (TIPS) also adjust to inflation, preserving investors’ capital in real terms.
• Cash and Inflation: Holding too much cash in an inflationary environment can be detrimental, as inflation erodes its value over time. While maintaining liquidity for emergencies is prudent, holding excessive cash can significantly reduce purchasing power in the long term.

In an inflationary environment, some assets may lose value, while others can help protect and grow wealth. By understanding how inflation affects each asset class, investors can make informed decisions to safeguard their portfolios and preserve purchasing power.

Are Bonds Back in an Inflationary Environment?

Source: Dimson–Marsh–Staunton (DMS) Dataset, CFA Institute Research Foundation (2016b, 2016c).

Some investors are allocating aggressively to fixed interest rate securities, already anticipating a declining rates cycle. While peak inflation rates may have passed. Expectations are only slowly anticipating higher-for-longer inflation.

We believe, that although nominal bond yields have risen, negative real interest rates and the current geopolitical environment, characterised by escalating tensions between major consumer and supplier regions, coupled with depreciating currencies in emerging markets, does not present a risk-free hunting ground for Bond and EM investors.

In a higher inflation environment, bonds are expected to structurally underperform a portfolio of companies – at reasonable valuations – that are earning Returns on Capital in line with (or above) long-term average industry returns. Investing in times of inflation requires focus on well priced high quality companies that can structurally sustain pricing power over the long-term.

Strategies for Safeguarding our Financial Future

Inflation erodes the purchasing power of money, meaning that over time, the same amount of money can buy fewer goods and services. Inflation can expose companies with weak fundamentals or excessive debt. Therefore, it is crucial to focus on investing in high-quality companies with strong balance sheets, pricing power, and sustainable competitive advantages. Such companies are better equipped to weather inflationary pressures and maintain their profitability.

But to find great companies that can sustain and compound earnings, are not easy. Of the US firms listed in 1900, more than 80% of their value was in industries that are today small or extinct; the UK figure is 65%. Railroads, textiles, iron, coal, and steel all declined precipitously.

Industry Weightings in the USA and UK, 1900 Compared with 2015

And the pace of change has accelerated. Unlike the railway companies of old, to sustain performance, great companies need growth without the need for high, or additional, invested capital. Companies that can show the best growth with the lowest capex and financing needs will form the best investments during times of inflation.

Great companies, that can sustain growth for the next 20, even 30 years, are not easily found, but when you do, your chances of successful investment improves dramatically.

The history shows that over the long run, there is an increased reward for investing in equities when investing in times of inflation.

Foreign exchange fluctuations (over the long-term) mostly responding to relative inflation, and the impact of exchange rate fluctuations on investment returns has been relatively modest.

We advise to carefully evaluate the profile of fixed-income and emerging markets investments during inflationary times and explore alternative strategies to mitigate potential losses.

The Impact of Inflation on Real Capital Accumulation

One of the key challenges inflation poses is its effect on real capital accumulation, which directly impacts a company’s ability to grow and increase shareholder value when investing in times of inflation.

To illustrate this, consider a company earning an 8% return on equity capital. These earnings, after accounting for depreciation, are intended to allow the company to replace its productive assets. However, inflation complicates this process.

Imagine a company that pays out half of its earnings yield as dividends, leaving 4% available for reinvestment. In a low-inflation environment, say 2%, a significant portion of these retained earnings will be absorbed by the rising costs of maintaining the current level of production. Specifically, 2% must be reinvested simply to replace working capital (such as receivables, inventories, and fixed assets) at inflated prices. This reflects inflationary dollar growth, but not real growth in physical output.

That leaves only 2% of the retained earnings to finance genuine growth—expanding the company’s physical output. If population growth is around 1%, the result is a real gain of just 1% in per capita income. Essentially, inflation reduces the company’s ability to generate real economic growth, as a significant portion of retained earnings is used merely to keep up with inflation.

For companies, this means inflation can distort their ability to accumulate real capital and finance future expansion, highlighting the importance of proactive strategies to manage inflationary pressures. Without careful planning, the rise in costs will erode the capital available for genuine growth, leaving only nominal gains that mask the true impact on profitability and productivity.

Conclusion

Many companies who don’t earn high returns, will be faced with no real retained earnings with which to finance physical expansion after normal dividend payments. A combination of high inflation and moderate returns on equity reduce the stream of corporate capital available to finance real growth or spend on social challenges. By understanding how inflation affects each asset class, investors can make informed decisions when investing in times of inflation.

By adopting these strategies, investors can safeguard their portfolios and navigate the challenges of an inflationary environment with greater confidence.

For institutional investors navigating this environment, our Non-Discretionary Investment Advice provides the analytical framework and ongoing due diligence needed to build inflation-resilient portfolios while maintaining full fiduciary control.