After a four-decade hiatus, inflation is once again rearing its ugly head. Its impact has been felt at the checkout counters and gas pumps for months, and now it’s shaking up the markets. Year over year, U.S. wholesale prices were up 10% in 2021—a rate of increase not seen for four decades. So, how did we get here?
Since the beginning of the pandemic, the Federal Reserve has stepped up quantitative easing to levels not seen before, swelling the federal balance sheet to just under $9 trillion. This was a measure to bolster supply and stimulate economic growth in the face of a Covid-19-induced economic downturn. But with factories shutting down and people staying home, the accelerated growth of the money supply surpassed the growth of production. That caused the price of goods to increase. That is the classic definition of inflation: Too many dollars chasing too few goods.
During the pandemic, many consumers chose to save their money rather than spend it. Also, with limitations on travel, leisure and restaurant dining, their options for spending money were limited. Then, as Covid-19 restrictions were lifted, consumer spending rose to pre-pandemic levels, increasing demand amid limited supplies, resulting in higher and more sustained inflation.
The Impact Of Inflation On Stocks
Commodities have been particularly hit hard with this bout of inflation. We’re seeing the prices of some commodities skyrocket, but that doesn’t necessarily translate to retail price inflation. That’s because consumers don’t buy commodities. Companies buy commodities with which they produce the goods consumers buy. As a result, the initial impact of rising inflation is on company profits, not consumer prices. To remain competitive, many companies will absorb the higher production costs as long as they can to maintain sales revenues, thus hurting their profits.
However, some companies are better able to avoid that conundrum. Companies with higher gross margins are substantially inoculated from the impact of inflation. What is gross margin? Gross margin is sales less the cost of goods sold (COGS). In other words, it’s the amount of money a company makes after the costs of producing the goods it sells and the services it provides. Consider an example of two hypothetical companies:
Big Global Brand Company A has gross margins of 70%. That means it makes things for $3.00 and sells them for $10, resulting in a gross profit of $7.00.
Smaller Brand Company B on the other hand has a gross margin of 30%. So it makes things for $7.00 and sells them for $10 for a gross profit of $3.00.
Company A Costs $3.00 Sells for $10. Makes $7.00
Company B Costs $7.00. Sells for $10. Makes $3.00
Impact of 5% inflation
Company A Costs $3.15 Sells for $10. Makes $6.85 (15 cents lower profit)
Company B Costs $7.35 Sells for $10. Makes $2.65 (35 cents lower profit)
With inflation at 5%, Big Global Brand Company A’s gross profit would be cut by 15 cents, but Smaller Brand Company B’s profit would be sliced by 35 cents, more than double Company A. That sounds dire for both companies, except that Company A could more easily offset the cost increase by raising its prices with little if any impact on its sales due to the strength of its brand. However, Smaller Brand Company B probably could not get away with raising its prices by as much without it severely impacting its sales.
With its higher gross margins, Company A’s gross margin would decrease from 70% to just 69%, while Company B’s gross margin drops from 30% to 27%, which is a higher hurdle to clear in the face of 5% inflation. The point of this exercise is that the higher the company’s gross margin, the better its profitability is protected from inflation.
However, inflation can impact companies in other ways, such as valuations. If a company’s cash flow growth can’t outpace inflation, it can negatively impact the value of future earnings, thereby increasing the cost of capital. That’s why many younger technology companies whose valuations are counting on future earnings have been severely affected in the stock market. Companies with the ability to grow cash flow faster than the rate of inflation can maintain their valuations better.
What To Expect From Here
The current bout of inflation seems to have taken the markets and Fed, and everyone else who viewed it as transitory, by surprise. That means we can expect more volatility as valuations get whipped around. However, in terms of the impact of inflation on the fundamental performance of our companies, we can be sure they will weather the storm much better than most.
The current data indicate higher inflation will be with us until at least midyear, at which point it can be expected to taper off. It’s anticipated that the Fed will raise rates at least three times in 2022, starting in March.
Your Biggest Risk Is How You React
When the stock market turns volatile, the most significant risk to investors is not a declining market, but rather, how they react to them. The instinct to abandon the market, triggered by the fear of losing money, can be overpowering. Riding out a volatile market is never easy. It doesn’t help when investors frantically scour their stock accounts every day. It’s important to remember that, throughout stock market history, market declines have always been a temporary interruption of a more enduring positive long-term trend.