The stock market hasn’t been a fun place to be of late. A rally since mid-June may have led some to believe the bottom was in – but that could be wishful thinking. PE ratios have contracted sharply, and earnings could be about to follow suit in many sectors, if early signs from the current reporting season both here and in the US are any indication of what comes next.
The culprit, of course, is inflation. We could trace the root cause of the price spike back further still; pandemic induced supply chain tightness exacerbated by the war in Ukraine, monetary and fiscal policy errors in response to Covid, or indeed just a long period of central bank largesse dating back to the GFC. Or even further, perhaps, to decades of malinvestment, most recently around energy infrastructure as a partial consequence of environmental policy.
I could go on, but you get the gist. Not that it really matters, because we are where we are, and facing the simple fact that high and rising inflation is making life very difficult for investors.
Inflation is certainly the cause of the significant derating of growth stocks – put simply, high inflation means the current, discounted value of their future cashflows is worth significantly less. Or, looking at another way, as interest rates rise, and the return you can get from ‘safe’ assets like Treasuries or Gilts rise with it, then the expected returns from more risk equities needs to be higher – the converse of which is that the valuation needs to be lower. Until inflation shows signs of moderating, this trend is unlikely to reverse.
Oversimplified mechanics of stock market maths aside, inflation just makes life difficult for all sorts of companies, which find themselves facing soaring costs of doing business on the one hand – from raw materials and power to higher wage bills – and customers unable or unwilling to pay the higher prices companies need to charge to protect their margins.
It’s a balancing act that few companies can manage easily, and it’s still far from clear how long it will persist or what policymakers and central banks might do next.
That’s why seeking out ways to protect your investments from inflation still makes a lot of sense, and I’m not talking about the short-term rush into commodities that we saw as Putin’s tanks rolled into Ukraine. There’s lots of risks in that particular trade, as I discussed here.
If you’re really worried about the further effects of inflation on the stock market, then the obvious place to be is cash. And while it’s often suggested that you shouldn’t hold cash during periods of high inflation, lest its spending power be whittled away, that’s only true if you have to live on it. If the cash is eventually going to find its way back into the market, you’ll be able to buy a lot more in the future if the downturn does continue.
There is, however, a school of thought that you could end up worse off if you misread the market signals and mistime your re-entry - for instance, if the optimists are indeed right and the bottom is already behind us. Those that think this way, and prefer to stay invested, have plenty of market stats to back the view up, not least that many of the most powerful rallies come straight after the nadir and there’s a high risk you miss them when trying to play the timing game.
But if you subscribe to the adage that “time in the market beats timing the market”, you’ll need both nerves of steel – to wear the heavy falls your portfolio might suffer – and confidence that your investments will be able to survive whatever the economy can throw at them and eventually bounce back.
Along with their relative resilience to the aforementioned market mechanics, that’s one reason why fusty old defensives in sectors like telecoms and non-discretionary consumer goods have proved an oasis of relative calm in the current market storm (as I've found with my own investments).
As well as being cheaply valued relative to racy growth stocks, they also frequently sell the kind of stuff that households just can’t stop buying, like broadband connections or washing powder. And while they aren’t entirely immune from the ravages of inflation, results from Unilever (ULVR) and Reckitt Benckiser (RB.) this week suggest they’ve been able to pass on higher costs without driving too many customers away.
True, these are hardly the kinds of investments that set the pulses racing. But at times like these it can pay to be boring.