Learning to (Really) Love Inflation

The one lesson all investors must take to heart to prosper in the decade ahead

The US Consumer Price Index for January was 6.4% higher than the year ago month--more than triple the Federal Reserve’s often stated long-term inflation target of 2%.

The logical conclusion: The Fed is still far from done raising benchmark interest rates to corral inflation. And in fact, a working majority of central bank governors are indicating as much.

That sort of news triggered big stock and bond market selloffs last year. But investor reaction this time around has been decidedly mild. In fact, even after a larger than expected boost in the January Producer Price Index, the betting still appears to be the Fed is nearly finished raising rates—with a “peak” rate for Fed Funds somewhere between 5% and 5.5%, versus the current 4.5% to 4.75%.

It’s dangerous business to put much faith in forecasts of where the CPI or PPI will be in a month’s time, and especially what the Fed will do in response. But we can draw one clear conclusion from all of this: Investors are a lot more willing now to live with elevated inflation than they were last year. The big question is how long it will be before the wiser among them learn to love it.

Whatever the Fed does now, inflation isn’t going away any time soon. Rather, the trends driving it over the past year are becoming ever-more entrenched.

Number one is efforts by politicians on both sides of the Pacific Ocean to decouple the intertwined US and Chinese economies. Whether or not you believe geopolitics justifies this action, there is economic pain from driving apart such close trading and investment partners, with collectively almost 40 percent of global GDP.

After roundly criticizing Trump Administration tariffs during the campaign, the Biden Administration has since doubled down on them. And by demanding US businesses employ greater local content including labor, their moves are increasingly disrupting supply chains it took decades to build.

On the Chinese side, the cost of decoupling is slower growth. In the US, its higher costs for products and services, as manufacturing moves from cheaper and more efficient locales to higher priced ones. And with anti-US rhetoric as popular in China as China-bashing is in this country, both sides are likely to keep pushing along this mutually destructive road, regardless of consequences.

Continuing lack of investment in energy supply is another key driver of inflation. Oil, natural gas and wholesale electricity prices have dropped back from summer 2022 highs. But the primary reason is a lull in demand, caused by a mercifully mild winter in the Northern Hemisphere and recession worries.

The primary driver of energy cycles is supply, which after slumping investment for nearly a decade is now running well behind underlying demand. And the investment gap is only going to widen this year: Energy companies’ 2023 guidance indicates managements still see paying off debt, raising dividends and buying back stock as a better use of shareholders’ money, than risking multi-year investment to ramp up supply meaningfully.

That means when the Fed stops boosting interest rates, underlying demand will once again overwhelm supply and energy prices will rise again, feeding inflation. And don’t look for renewable energy investment to pick up the slack: Deployment in the US actually dropped last year under the burden of supply chain disruption, higher development and finance costs and the lack of commonsense US permit reform.

In the 1970s, wages and prices generally followed each other higher, pushing up inflation as the result. Companies’ margins were squeezed. But many were able to pass on much of their added costs to consumers and businesses. And government efforts to break the cycle such as the famous “Nixon Shocks” proved wholly ineffective.

In the end, it took sufficient global investment to reduce inflation to the levels Americans have enjoyed the last 30 years or so. That’s what it will take to quell inflation this time. And to the extent the Federal Reserve’s rate hikes discourage companies’ capital spending, it will prolong the cycle--just as massive rate hikes did in the 1960s, 70s and 80s.

Measures of inflation will vary from month to month. And with oil and gas prices backing off, higher interest rates discouraging investment and recession risk elevated, we will likely see lower CPI and PPI increases this year. But once the Federal Reserve declares victory and eases up, these underlying factors will start to work again pushing up inflation.

The key for investors is to not just get used to more inflation. It’s to position to capitalize on it. The companies we own must be able to control costs and pass increases they do incur onto consumers and businesses, so they can take advantage of the faster growth inflationary times usually bring.

Not every company will be up to the test. In fact, the lesson of the 1970s and 80s is the higher inflation goes in coming years, fewer and fewer will measure up. That means investment strategies based around betting on market and sector indexes—so-called “buying the basket”—won’t work nearly as they did during the bull market that ended in 2021. In fact, they’re likely to destroy a great deal of wealth, just as they did from 2000 through 2009 when the S&P 500 lost more than a quarter of its value.

But while average won’t cut it, the 1970s proved exceptional individual companies will actually produce bigger gains than they did during the late great bull market. The key is separating the wheat from the chaff to leverage individual company business performance—and that means buying stocks first, rather than simply relying on sector or market bets.

Generating reliable free cash flow after dividends is a major advantage to companies in inflationary times. Not only can they avoid debt finance at a time of rising interest rates. But the value of their existing debt drops, making it easier to retire. And free cash flow can be devoted to making accretive acquisitions as well as raising dividends faster than the rate of inflation.

Global pharmaceuticals giant Abbvie (NYSE: ABBV) is a good example of a high yielding company set to generate a mountain of free cash flow, after all CAPEX and dividends. The company’s wildly successful Humira treatment is now facing competition from biosimilars in the US, with the result sales are likely to drop this year. But management has long prepared for this moment by launching new treatments and business lines. And few industries are able to pass their costs along to consumers as effectively as developers of life-saving treatments.

Companies with largely price inelastic products—where an increase in costs to consumers doesn’t trigger a corresponding decline in demand--have also historically been inflation winners. Tobacco companies are one good example and several like Altria Group (NYSE: MO) are also projected to generate substantial free cash flow.

Surprisingly, selected electric utilities also appear very well positioned for this era of inflation—especially companies able to reduce the fuel costs they pass through to consumers and businesses by ramping up solar generation. That’s what NextEra Energy (NYSE: NEE) has been doing the past decade plus.

Commodity prices almost by definition rise during inflationary times. This time around mining companies like BHP Group (NYSE: BHP) should benefit more than usual, as resources needed to deploy electric vehicles, solar generation and the like see geometrically increased demand. And best in class producers of oil and gas along with midstream infrastructure companies are only in the early innings of a multi-year upswing, which should end with even higher prices for stock than we saw at the peak of the previous cycle in 2014.

Finally, don’t discount the prospects of well-managed companies operating in industries where investors fear the worst about inflation’s impact on costs—but which have demonstrated an ability to roll with the punches. That appears to be true of food products company Kraft Heinz Co (NYSE: KHC), which has actually regained investment grade credit ratings and accelerated its growth rate even as inflation has picked up steam.

Of course, even picking the right companies will only get you so far. To really make inflation your friend, you’ve got to buy at the right time and in the right measure. And that also means being willing to take money off the table with sales from time to time to hold in cash, which is far less painful with money market funds yielding north of 4 percent.

That’s the kind of work my partner Elliott Gue and I have been doing for investors at our company Capitalist Times for more than a decade—and before that since the 1980s as hired hands for others.

But no matter what strategy or advisor you choose to rely on, taking control of your wealth now by resolving to focus on individual stocks—not sectors and index ETFs—is the first step to making future inflation your friend. And in the decade ahead, nothing will be more important to preserving and growing your wealth.