Welcome to Soundbites, weekly insights on market trends and investment strategies, brought to you by Investment Executive and powered by Canada Life. For today’s Soundbites, we’re talking about equities in inflationary times with Marcus Bellander, senior analyst with C WorldWide Asset Management. We asked if equities can act as a hedge against inflation, and the real culprit of reduced returns on equities. And we started by asking if Warren Buffet was right to suggest inflation “swindles” equity investors.

Marcus Bellander (MB): In 1977, Warren Buffett wrote an article titled, ‘How inflation swindles the equity investor.’ And, in this article, he concludes that the earnings of the S&P 500 companies did not increase by as much as one would have expected, considering the very high inflation that characterized the 1970s. But I think that there are more parameters to consider than Buffett did at the time. Profits can increase even if return on equity is unchanged. And, ultimately, I think that shareholders are probably most interested in the growth of a company’s profits. The second thing to keep in mind is that inflation is not the only thing affecting the profitability of companies. The real culprit could be weakened economic performance, rather than inflation, because during periods of high inflation, central banks raise interest rates, right? So, consumption falls and economic activity decreases. And you could say that I’m splitting hairs here maybe, but the point I’m trying to make is that it’s not inflation in itself that harms the economy, but rather the things we do to bring inflation back down.

Inflation dynamics

MB: Sometimes we talk of inflation like it’s some creature that lurks in the shadows and it occasionally jumps out and rears its ugly head. And I suppose that’s how regular folks perceive it. But I would argue that the perspective is a little bit different for companies. Inflation is not something that befalls companies. It is something they create, so to speak. But when all companies raise prices at the same time and at the same pace, their costs and their revenue rise at the same pace, then profits also rise at that same pace. If everyone knows the rules of the game, it’s a zero-sum game. An inflationary shock can certainly lead to temporary profit declines for some companies. But supposedly almost all companies will catch up eventually. It just takes time. It’s still a zero-sum game. It just takes time to play out. And, secondly, if your stock portfolio reflects the broader economy, many of your companies may lose a little — for example, because their transportation costs increase — but a few of the companies that you own will gain a lot. So, if you’re well diversified, you are better hedged against inflation.

Inflation and fixed income

MB: I think people link inflation with fixed income, first of all. I mean, we often talk about real interest rates, but we almost never talk about real returns on equities. And in one way we don’t have to. Because if we have a well-diversified equities portfolio, and we have a long-term mindset, then we are basically hedged against inflation. But in some instances, I think it is important to consider inflation also, when you’re an equity investor. And some people are baffled by the fact that the S&P 500 is so close to its all-time high. But that all-time high was two years ago. And inflation, in aggregate, has been 11% or 12% since that all-time high. So, in real terms, the value of your stock portfolio is lower than it was two years ago.

And finally what equity investors should keep in mind in inflationary times

MB: In times of inflation, well-diversified, long-term equity investors really don’t need to do much. They are protected against inflation. But, of course, for stock pickers with concentrated portfolios,  they might want to focus on companies that can quickly pass on higher input costs to their customers. And, of course, if you think that central banks will cause a severe downturn in their attempts to bring down inflation, you might want to consider the so-called non-cyclicals, or the companies that are less sensitive to the swings of the economic cycle.

Well, those are today’s Soundbites, brought you by Investment Executive and powered by Canada Life. Our thanks again to Marcus Bellander of C WorldWide Asset Management. Visit us at investmentexecutive.com, where you can sign up for our a.m. newsletter and never miss another Soundbite. Thanks for listening.

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Funds:
Canada Life International Concentrated Equity Fund - mutual fund
International Concentrated Equity - segregated Fund
Fonds:
Fonds concentré d’actions internationales Canada Vie - fonds commun de placement
Concentré d’actions internationales - fonds distinct