Over the course of the past month, Federal Reserve Chairman Jerome Powell has repeatedly commented on the potential risks that persistent high inflation could inject into capital markets and the wider economy. He reiterated these concerns during his July 28 press conference following a meeting of the Federal Open Market Committee. The central bank has pledged to act in the event of runaway inflation. However, it remains to be seen whether it can live up to that promise.
As I discussed last week in Part 1 of this investigation into the impacts of increasing inflation, the Fed has pledged to act in the event of runaway inflation. However, it remains to be seen whether the central bank can live up to such a promise.
With inflation edging up noticeably for the first time in years, capital markets are bound to be affected. Investors accustomed to an ultra-low interest rate environment may soon have to rethink their strategies and allocations, a fact hammered home by a raft of reports coming out of Wall Street research departments in recent months.
AllianceBernstein: Big opportunity in cheap value stocks
AllianceBernstein Holding LP (AB, Financial) has been talking about inflation since the start of the year. In March, the investment firm published an investor’s guide to inflation to help explain the implications and impacts of a changing market environment on investors’ portfolios:
“It’s been a long time since investors have had to worry about inflation. But a strong economic rebound from the pandemic could trigger higher inflation, requiring investors to think about portfolio adjustments and to reconsider some asset classes shunned over the last decade.”
After more than a decade of near-zero inflation and near-zero interest rates, I feel it is sound advice that investors actively re-evaluate their portfolio allocations in the face of the new trend. But where should investors put their money to get the most out of the new market environment? According to AllianceBernstein, investors ought to consider rebalancing their equity portfolios to favor value stocks over growth stocks:
“Growth stocks valued on earnings and cash flows expected many years in the future have seen their price/earnings multiples expand as rates have fallen. If rates rise, this trend could quickly reverse, especially for hypergrowth companies valued on earnings that haven’t happened yet...Investors in growth stocks should check that their allocations aren’t too exposed to very expensive companies with weak current earnings power. Growth companies with sustainable business models, consistently high profitability and relatively attractive valuations will be better positioned for an inflationary outbreak. On the other hand, value stocks could benefit from inflation. As COVID-19 vaccinations are increasingly rolled out and countries make progress in combating the pandemic, we believe investors will gain confidence in the trajectory of the nascent economic recovery...With global value stocks trading at a record 52% discount to growth stocks at the end of February, we think investors should consider initiating or increasing value exposure in equity allocations.”
Value stocks have gotten little love in recent years, a fact that many disciples of the Warren Buffett (Trades, Portfolio) school have lamented more than once. However, I see a compelling case for believing that value’s day in the sun may be near at hand.
Wells Fargo: Rising commodity prices to boost cyclical sectors
Wells Fargo Investment Institute, the research arm of Wells Fargo & Co. (WFC, Financial), is among the Wall Street heavyweights to have weighed in on the issue of inflation. In its mid-year market outlook published last month, Wells Fargo highlighted the potential impact of inflation, which it sees rising as the result of demand widely outstripping supply across the economy. From raw materials to labor, prices are on the rise thanks to overwhelming demand. However, Wells Fargo ultimately concluded that the extreme robustness of the economic recovery will more than a match for the inflationary headwind.
Based on its latest marco assessment of the potential opportunities emerging out of the post-pandemic bull market and economic expansion, Wells Fargo has advised investors to increase their exposure to cyclical sectors in the back half of 2021:
“We suggest an approach to U.S. equities that includes larger allocations to cyclically oriented large-cap stocks and fast-growing small caps…Accommodative monetary policy, fiscal stimulus, and strengthening corporate investments in plant and equipment should support U.S. large-cap equity sectors that tend to outperform early in an economic expansion. Among the sectors in the S&P 500 Index, we believe Industrials, Materials, Financials, and Energy fit this bill.”
I largely agree with Wells Fargo’s assessment that surging commodity prices in everything from industrial metals to agricultural products can help support cyclical industries as part of a strong and sustainable economic expansion.
My take
Inflation worries are visibly on the rise, with a growing number of investors beginning to wake up to the magnitude of the potential risks, as well as the potential opportunities, that may emerge as a result of renewed inflation. I have discussed just two of the many potential plays that are emerging out of the nascent economic expansion.
The pre-pandemic economic expansion undoubtedly fueled surging growth stocks and left value names in the dust. This new post-pandemic expansion, however, coming as it does with expectations of higher inflation and rising interest rates, may see a reversal of fortunes for growth names buoyed by overly optimistic valuation multiples.
If the recovery continues apace, I see ample reason to expect further tailwinds for both commodity prices and cyclicals. However, I would caution investors to also consider the risk, however unlikely, of future lockdowns or supply chain disruptions. While not a high-probability scenario at present, investors should know from recent experience that low-probability events do happen.
