Opinion: Inflation makes everything we buy more expensive and once stagflation sets in things could get even worse

Last month I examined the culprits causing global inflation, including rising interest rates, ongoing supply chain problems (China locks down cities), and rising energy and fertilizer prices.

That brings us to stagflation. If rising costs (inflation) were foreseeable, wages would match this increase and the impact on commodity consumption would be favourable. That has been anything but the case lately. Although wages have risen by 3-4%, they are well behind official inflation figures and are being let down by actual inflation. This is before high interest rates and high fertilizer prices caused by the war in Ukraine hit food production, food prices and consumer wallets.

As inflation outstrips wage growth, consumers feel poorer and with it their ability to buy durable goods. In this way, inflation becomes a drag on economic growth and is called stagflation.

The impact of inflation on the economy will depend on the difference between the inflation rate and wage growth. The higher the difference between these two numbers, the more inflation slows down the economy and causes stagflation.

No recession in sight

We’re not worried about a US recession.

Recessions are natural cleaning mechanisms for the economy. As the economy expands, companies begin to drip with fat. Their processes are loosening up, they’re hiring too many people, they’re piling up too much inventory. Recessions are nature’s diet plan for businesses that need to lose some weight. Recessions aren’t fun (especially for those losing their jobs), but historically they’ve been short-term disruptions between economic expansions.

To see how the US economy and stocks will react to this high-inflation environment, go back to the late 1970s and early 1980s. Or you can just look at the last 20 years and reverse it.

For the past 20 years we have had falling interest rates and low inflation, which in turn has resulted in never-ending (with only brief interruptions) increases in house prices. This put extra money in consumers’ pockets and drove up the prices of all assets (particularly stocks), which in turn boosted consumer confidence as people felt more affluent and satisfied with their spending.

The tailwind of the past becomes the headwind of the future.

credit flowed freely; Stock market multiples widened. Despite the tripling of the national debt, interest payments on US debt as a percentage of the federal budget are near an all-time low. Low interest rates and government spending have a stimulating effect. If you reverse all of this now, you get anemic long-term economic growth and shrinking multiples in stock markets. The tailwind of the past becomes the headwind of the future.

For the last 20+ years, whenever the US economy has faltered, Uncle Fed has bailed it out, lowering interest rates and injecting liquidity into the market. Both the economy and the market were back in the running. But the pain we were spared did not go away; it was bottled in the pain jar. This glass is now almost full and leaking. Today, to prevent inflation from turning into hyperinflation, the Fed must do the opposite of what it is used to doing in the 21st century – raise interest rates.

Of course, the economy is a complex, self-regulating mechanism, and so the bleak picture I’ve painted here may or may not be accurate. One should never underestimate human ingenuity.

Read: The antidote to stagflation is to boost supply by investing in economies and people around the world

However, as investors, we must prepare for the worst and hope for the best. Since hope is not a strategy, let’s focus on preparation. The current dot-com 2.0 bubble still has plenty of room to deflate (we rummaged through the debris and found nothing we liked). Given this expectation, combined with generally high equity market valuations and a gloomy global economic picture, it is clear why our company’s portfolio is extremely conservatively positioned.

We deliberately aligned the portfolio to a low-growth environment. The majority of the companies we invest in don’t march to a predictable blip in the economy. Your profitability shouldn’t change significantly if the economy goes through sustained contraction or low (real) growth. Yes, the US market is expensive and the economy is full of uncertainty; but we don’t own the market, we own carefully selected high quality, undervalued companies.

This includes defense companies, which should do well in an inflationary environment given that their contracts are inflation-linked and their customers (US and EU governments) are able and willing to buy no matter what. I’ve written extensively about defense contractors here.

Pipelines (for oil, natural gas and refined chemicals) should also benefit from inflation as their costs are mostly fixed and backed by large capital expenditures. They are also mostly monopolies and therefore have pricing power. Like the defense sector, these companies will benefit from Russia’s war with Ukraine as the US will produce and export more oil and natural gas. Read our thesis on pipeline companies here.

Vitaliy Katsenelson is CEO and Chief Investment Officer of Investment Management Associates. He is the author of Active value investing: making money in range-bound marketsand The Little Book of Sideways Markets.

Here are links to more of Katsenelson’s views on the inflation landscape (read, Listen) and how to invest in inflationary times (read, Listen). For more investing insights from Katsenelson, visit ContrarianEdge.com or listen to his podcast Investor.FM.

More: Inflation will be higher for longer – and you won’t like what comes next

Plus: Oil prices could become “parabolic” and put the global economy in a “critical situation,” says Trafigura boss

https://www.marketwatch.com/story/inflation-is-making-everything-we-buy-more-expensive-and-once-stagflation-hits-things-could-get-even-worse-11654761515?rss=1&siteid=rss Opinion: Inflation makes everything we buy more expensive and once stagflation sets in things could get even worse

Brian Lowry

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