Equities in an Inflationary Environment | Barita Insights | June 7, 2022

Analyst Insight

Introduction
As economies pivot from a focus on dealing with the pandemic, an emerging theme that has remained constant has been that of the elevated inflationary environment. As businesses grappled with restrictions on movement and operation throughout the pandemic, the ensuing supply chain disruptions created an imbalance relative to consumer demand, driving an acceleration in inflation. The issue has been compounded by the emerging conflict between Russia and Ukraine, which has resulted in increased commodity prices. To combat this inflation, Central Banks have been aggressively employing interest rate hikes with other tightening measures on the cards. As such the conundrum that exists for investors is where to position in the current investment climate? We are of the view that equities remain an attractive area that investors can position in for attractive returns.

Inflationary Implications
One of the challenges that presents itself in an inflationary environment is the impact on interest rates and the degree to which it can create an element of uncertainty for a company’s cost structure and growth. As Central Banks move to fight inflation with higher rates, market participants tend to adjust their positioning across asset classes as riskier assets become incrementally less attractive. Consequently, investors will require a higher return for the risk taken in equities as yields adjust higher on bonds and other lower-risk securities. Against this backdrop, an investor must carefully analyze various asset classes and develop a strategy that can yield returns adjusted for inflation. Outside of Treasury Inflation-Protected Securities (TIPs) and inflation-indexed bonds, investing in bonds may seem counterintuitive. Inflation coupled with rising interest rates generally presents a danger to fixed income securities. Real estate in its purest form, can be an attractive asset class, as it allows owners to pass on costs to tenants which can be adjusted for inflation.However, pure-play real estate investing is not an option that is readily available to most retail investors.

Why Equities?
Historically, equities have outpaced inflation in the long-run. In the period from 1914 to 2022, US inflation has averaged 3.25%annually, while the S&P 500 Index has provided an average annual return of 10.49% from 1926 to 2021. Equities have traditionally been viewed as an inflation hedge. The mechanism behind this thinking is grounded in the idea that generally, companies can pass on their rising costs to consumers over time, thereby maintaining their margins at higher price points. Notwithstanding, this is not the case across all companies or industries, as other factors come into play, such as the competitive dynamics of the market and the degree to which demand for a product is discretionary. As such, a key thought that should guide an investor when investing in equities within the current paradigm should be the pricing power of the Company and the nature of the product it sells and the market it targets. Additionally, another area that requires attention when choosing where to allocate capital within your equity portfolio is the company’s capital structure and general financial profile. As highlighted above, rising interest rates normally accompany a sustained increase in inflation. As such the cost of debt financing will increase for companies. Companies that are looking to fund strategic expansion or working capital needs with debt will be more limited in their options due to the elevated cash flow requirement to service interest cost. Furthermore, companies that have a higher debt exposure on their balance sheet already are at increased risk. This is due to the cost of interest on new debt facilities that can be used to replace existing debt being higher, which will impact earning subject to the degree to which the company can reduce its liabilities as they come due. As such, in this paradigm, a rule of thumb to follow is to skew towards developed companies that have a strong balance sheet with modest debt, high liquidity and that are cashflow positive. Combined, these factors can enable companies to continue to grow profits within an inflationary environment, while reducing the potential volatility of earnings.

Conclusion
Despite the volatility in the markets and the current inflationary environment, there are areas within the equity market that will remain attractive. Investing is a long-term endeavour and may require the shifting of strategies within the portfolio. However, it is important to understand the market that a company operates in, its key driving factors, and how changes in the broader macroeconomic environment will impact the line items that are most impactful to earnings.