Interactive Investor

Why equity investors should not fear inflation

16th October 2017 09:11

Ken Fisher from ii contributor

The UK's 'cost of living crisis' is overinflated

Last month, we covered the swinging pound's portfolio impact. But sterling's effect on portfolio returns isn't investors' only currency concern. Higher inflation, stemming partly from the weaker pound, is also high on the list. Headlines regularly warn the "cost of living crisis" will torpedo the UK economy and, by extension, markets. I've studied this stuff a long time, and there is no evidence today's inflation rate is problematic for stocks. This is another brick in the bull market's wall of worry.

You can use simple logic against fears like this. Markets pre-price all widely known information. Everyone knows about UK inflation! It's all we've heard about for months, as CPI rose from 0.9% y/y last October to 2.9% in August.

The presumed knock-on effect on consumer spending is old news, too. Everyone knows it slowed in Q1 and Q2. So do stocks! And they don't seem to mind. Year-to-date, UK stocks are up 7.9%, a whisker away from world stocks' 8.5% (in GBP). No inflation trauma there!

To say inflation's market impact is merely delayed is to fundamentally misunderstand how markets work. It can't suddenly sneak up on them. Stocks aren't locked in some sensory deprivation chamber, unaware of rising CPI. Their ongoing rise isn't blissful ignorance - it's their way of saying, "we don't care." Trust them.

Trust history, too. Remember when inflation topped 5% in 2011? UK stocks outperformed the world that year. Yes, they fell 1.8% (vs. the world's -4.8%), but that had much more to do with the eurozone debt crisis, which drove a steep summertime correction.

If the UK could outperform and escape recession with inflation over 5% - and the global economy overall weaker thanks to the eurozone's double-dip recession - it can do just fine today, with prices tamer and the world much stronger.

Inflation confusion is normal. No one likes paying higher prices. But it's important to scale. Today's inflation seems high because prices were snoozing from 2014-2016. Few stop and consider that inflation spent most of 2013 hovering near today's levels - another great year for Britain's economy and markets. No inflation wallop then, even though real wages were still falling, just like now. UK inflation also hovered near 3% in 1995 and 1996 - a smashingly good time for markets and growth.

None of this means inflation never bites. 1990-1991 was a bad time for the UK. But 8% inflation was a symptom of the ERM crisis and double-dip recession, not the cause. Sky-high inflation in the 1970s and early 1980s is also a painful memory for many, with some bad spells for the UK economy and markets. But saying inflation caused problems then ignores the impact of price controls. Then, too, the solution was hiking interest rates far and fast. In the US and UK, stocks mostly drifted higher until government policy to battle inflation wreaked market havoc.

But that is an extreme case, and UK inflation is nowhere near 1970s levels. Nor is it likely to get close. The pound is up this year. Soon the earlier weakness will be out of the year-over-year inflation math. M4 money supply growth has eased off last year's torrid pace. So has loan growth. Never forget, inflation is always and everywhere a monetary phenomenon. As money flows more slowly, prices should settle.

Even if CPI stays elevated, stocks have already proven they are a good long-term inflation hedge. When you own a stock, you own future earnings - which inflate along with everything else. You don't necessarily get that hedge with bonds: Fixed interest doesn't rise with inflation, so the real value of any bonds you own falls. Inflation eats cash, too.

So, wherever UK CPI goes in the coming months, own stocks - UK and global firms. Companies are making money hand over fist. Let their earnings fight the inflation bogeyman for you.

What do you do if Materials look iffy but big firms are hot? Buy DowDuPont, the diversified chemicals giant formed when Dow and DuPont merged. It's primed for bigtime profit growth thanks to healthy chemicals demand, strengthening global economic expansion and post-merger cost-cutting magic. While it is a tad pricier than peers at 18 times my 2018 earnings estimate, its 3.2% dividend yield is hard to pass up.

In a hot year for Emerging Markets, few are hotter than Reliance Industries, India's second largest petroleum refiner. Oil drillers hate low prices, but refiners love them. Strong Asian demand for refined oil products should drive revenues, while range-bound oil prices keep costs low.

As a bonus, Reliance's new Telecom venture, Jio, adds big opportunity. New subscribers are flocking to Jio's world-class ecosystem, sophisticated nationwide network, faster data and lower pricing. Some call it expensive at 15 times my 2018 earnings estimate, but that's a fine price to pay for solid potential in a robust bull market.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Ken Fisher has been regularly featured in the financial media for over 30 years and was the pioneer of the Price-to-Sales ratio as a tool for investment analysis. Since 1979, Fisher Investments and its subsidiaries have provided customised guidance to institutional and individual investors. For more information on Ken Fisher and Fisher Investments UK please visit www.fisherinvestments.com/en-gb.