Imagine inflation in any year (Year X) is 3%. If the return on your investment assets in Year X is not at least 3%, your investment capital is worth less in real terms when translated into goods and services. Imagine if the return from bonds in Year X is 4% (not bad), but then factor in the effect of inflation which reduces the real value of the currency. Assuming our inflation in Year X is 3%, the real return from bonds in our example is reduced to just 1% (bond return of 4% minus inflation of 3% = 1% of real return). Now imagine if the rate of inflation in Year X had been 5%, or 8%. Then our real returns turn heavily negative. Investors must therefore seek investments with returns greater than the rate of inflation.
Investors in the developed world have enjoyed low, stable, and predictable inflation since the 1990s. This has allowed investors to focus on generating returns without having to worry too much about inflation as a risk. If inflation is 1% or 2% every year, this matters little to the real returns on bonds, equities or real estate which have been consistently strong for several decades.
This, however, may be about to change. The pandemic has shaken the global economy and resulted in dramatic changes to government and central bank policy. The US reported consumer inflation for April 2021 of +4.2%, the sharpest acceleration in prices in almost 15 years and close to the highest rates reported in decades. Inflationary fiscal and monetary policy, combined with pent-up demand and an economic recovery could see much higher rates of inflation in our near future. Investors must be prepared for this.
In any period of higher inflation, cash has been a poor performer. In a low interest rate environment, cash offers little protection to investors. It loses its value at the rate of inflation over time, with no mechanism to positively adjust in value. Bonds similarly have little capacity to adjust in price to reflect changes in inflation. Most bonds are fixed income instruments, this means the rate of return is fixed at a certain rate, say 5% per year. If inflation rises, as shown in the previous example, the real rate of return on fixed income assets declines.
‘If not bonds or cash, where then?’ many will ask, in relation to where capital should be allocated to weather any transitory inflation storm. ‘Equities with pricing power!’ is the emphatic response from the investment team at Dominion. Any business which has pricing power is able to pass on inflation in costs to its customers as price rises. These companies often have dominant positions in their markets, face little competition, and sell unique products and services with scarcity value.
At Dominion, we invest only in companies that command pricing power and which are also growing profits at rates above GDP. We believe this combination of: (1) pricing power, and (2) growth, is a recipe for continued positive investment returns, whatever the inflationary environment may be in the coming years.
Disclaimer: The views expressed in this article are those of the author at the date of publication and not necessarily those of Dominion Capital Strategies Limited or its related companies. The content of this article is not intended as investment advice and will not be updated after publication. Images, video, quotations from literature and any such material which may be subject to copyright is reproduced in whole or in part in this article on the basis of Fair use as applied to news reporting and journalistic comment on events.
