Tim Hoyle, CFA, Chief Investment Officer
thoyle@haverfordquality.com
Last week, Kimberly Clark (KMB), the parent company to brands like Kleenex, Huggies, and Scott toilet paper, announced that it will be raising prices to offset rising commodity costs. Only a few days later, the U.S. Bureau of Labor Statistics (BLS) reported that the Producer Price Index (PPI) increased 1.0% in March. This is double expectations for a 0.5% increase and follows a 0.5% rise in February. Over the last year, the PPI has increased 4.2%. While the PPI is different from the CPI[1], it certainly portends what many expects: higher inflation is coming.
At Haverford, we continue to believe that higher inflation will be transitory, not systemic. There are several reasons we hold this view: 1) The drivers of low inflation, including technology and globalization, have not gone away. 2) One of the lessons learned from the Great Financial Crisis is that an increase in money supply is not inflationary in and of itself. 3) Supply constraints are temporary, and high prices tend to create excess supply.
A primary goal of any investment plan is to beat inflation, whether it be high or low. It is our experience that owning equities, particularly those companies with pricing power, are the best way to ensure the purchasing power of your investment portfolio beats inflation over the long-term.
Looking at 75 years of data, moderate inflation is the norm, and during these periods large companies can pass increasing costs onto consumers and decrease their own costs so that real earnings (earnings minus inflation) continue to grow. During the past 75 years, there have been 13 years when inflation exceeded 6%. Only in these years of very high inflation has corporate earnings growth lagged inflation. These periods of very high inflation were clustered in the years following WWII and the 1970s.
While corporate profitability mostly kept pace with inflation during these periods, stock prices were a casualty. The multiple investors were willing to pay for said earnings declined by close to 20% when inflation spiked.
Source Data: Robert Shiller. See data table below for a more detailed view of annual results based on the inflationary environment.
Conclusion: While unlikely, there is a possibility that the economy experiences a bout of run-away inflation in the coming years. If this occurs, blue-chip companies should be able to maintain earnings growth, for which investors will likely pay a lower multiple. But this is not a reason for despair. If history repeats, when inflation levels finally moderate companies will retain their higher earnings levels and investors will again pay higher multiples. When this occurs, investors will likely be able to look back and see that once again, equities didn’t hedge inflation. They beat inflation.
Source: Robert Shiller
[1] The PPI is different from the CPI in that it measures costs from the viewpoint of industries that make the products whereas the CPI measure prices from the perspective of consumers. – Investopedia.com
