Investment shift needed in our era of inflation

Don’t just expect today’s titans to thrive in the high-interest, interventionist times to come

We are witnessing the birth of a new economic era that brings more administrative control of key financial variables and also higher inflation. This ends an almost 40-year period of falling inflation, falling interest rates and a greater role for markets in determining prices.

Given this profound structural change, it is time to change how your savings are allocated. I previously wrote about why abandoning investment in government and private-sector bonds is necessary. But can investment in equities provide the returns that savers require, in this new era replete with inflation and active government intervention in resource allocation?

Buying a share gives legal title to a sliver of hope that is the difference between a company’s assets and its liabilities. This sliver, by which the value of assets exceeds liabilities, is known as equity. Like the “equity” in your home, its value can rise and fall depending on the value of the assets, but also on the value of debt and other liabilities. Unlike your home, equity in a company produces revenues and, after all costs are deducted, produces a cash flow which is either reinvested by management in the business or paid out to the owners of the equity as dividends or via share buybacks.

Investors in equities are thus financially exposed to both the difference between the valuation of the company’s assets and liabilities and to the difference between its revenues and its costs.

If the rate of inflation is rising and interest rates remain low, these are good economic exposures to have. If the cost of debt is depressed as selling prices and corporate revenues rise, then profit margins also usually rise and with them, corporate profits.

Low interest rates and high nominal GDP growth would also usually result in higher asset prices, and yet the value

attributed to the key liability — debt — would not rise. Put another way, a share in a company is a claim on real income-producing assets and such real assets benefit from rising inflation. Equities thus look well placed to benefit in the new economic era. However, as Warren Buffett famously remarked, “investing is simple but not easy.”

The “not easy” part of this equation consists of selecting equities that benefit from this new era — where those benefits are not already fully reflected in their price.

In any era or business cycle, corporate management has a great deal of flexibility to organize its activities to defeat what will increasingly be seen as an inflation tax.

That flexibility means equities are a good place to look to invest to ensure a rise in the real value of your savings; there is no such flexibility when you invest in a bond.

Bonds are also known as fixedinterest securities because there is no future flexibility in the coupon or principal that you will receive even as inflation rises.

Still, understanding the ability of corporate management to arrange the business to avoid the tax-like effect of inflation and grow dividends is not the same as saying that they will succeed.

In a period of high inflation in the 1970s, U.S. corporate management generally failed to beat the inflation tax and pre-tax margins did not expand. Interest rates rose sharply, higher interest expenses depressed corporate earnings and share prices declined.

Payments of pensions, still a key liability for many companies, will rise in a period of higher inflation and their burden on company cash flows will increase unless the assets that partially back such pensions start producing much higher returns.

Higher inflation usually also brings with it higher taxes, and as accounting profits rise postCOVID-19 and governments struggle to reduce debt burdens, higher tax rates are likely this time.

The conclusion, after assessing the many conflicting forces impacting corporate equity in our new era, is that while it is possible for management to defeat the inflation tax, it is not probable. This does not mean that equities are not the place to invest, but that you have to be selective.

When the 40-year trend of lower inflation, lower interest rates and greater resource allocation by markets comes to an end, it will be dangerous to invest your savings in an equity index. A broad equity index, such as the S&P 500, is weighted by the market capitalization of each of its members and includes mainly corporate success stories.

In most if not all cases, these broad indices are now dominated by companies that have successfully adapted to the era — low inflation, low interest rates and a greater role for markets — that we will be leaving.

Where management has the flexibility to change things, it is possible that these winners from this past four-decade trend can benefit again when those trends reverse. But the cards are stacked against any large company quickly and successfully implementing the wholesale changes necessary.

Any successes are reflected in the current share price, and past winners invariably attract high valuations. To quote Buffett again, “price is what you pay; value is what you get.”

Selecting shares of companies that will grow earnings and dividends in our new era is best left to professional investors, but not those among them who rely heavily on the weightings of companies within equity indices when selecting which shares to buy, nor those who use past corporate returns as a guide. Such professional investors are institutionally restricted from taking career risks by radically departing from current norms in selecting equity investments.

I cannot recommend any fund-management organization as being prepared to take such risks — in my experience these tend to be smaller firms, often organized as partnerships and advertising themselves as “value” investors.

The aim of depressing interest rates and boosting inflation is to transfer wealth from savers to debtors, so there are few places for investors to hide in this era of financial repression. That said, among the tens of thousands of companies listed globally, there will be many that will provide positive real longterm returns for investors in the era of financial repression.

That some equities can fulfil that role will mean that one day they, too, will become overbought and overvalued as their share prices rise. Find and invest in those companies today and you can beat the inflation tax to come.