Inflation’s Impact on the Market
January 31, 2022 | BY Our Partners at Equinum Wealth Management
The 2022 new year started with three consecutive weeks of downhill stock prices followed by a brief lapse into correction territory – as defined by a drop of 10% or more. This comes after the S&P notched 70 all-time highs last year – a record only second to 1995. Over the past two years, growth stocks have had all the fun, with large-cap and mid-cap growth stocks close to doubling the performance of their value stock counterparts.
Taking advantage of interest rates at near zero percent, growth companies were perfectly placed to borrow funds at historically low costs, using the funds to continue to expand and grow their market share.
The picture for 2022 includes growth stocks that have taken the brunt of the market dip. Why? Analysts are touting inflation as this year’s primary concern. Jerome Powell, Chair of the Federal Reserve Board, spent last year arguing that the surge in inflation during the pandemic was due to “transitory forces”. But by November of 2021, even he threw in the towel and told Congress that it’s “probably a good time to retire that word.” There are factors that contributed to inflation that do not seem to be transitory at all.
You may be wondering, “What does inflation have to do with the stock market? Prices are going up substantially , but shouldn’t that help companies make more money?” In fact, inflation negatively affects the stock market in multiple ways. Factors ranging from higher borrowing costs to lower margins. Historically, high inflation periods offer investors a much better return on their lower-risk fixed-income investments. This, in tum, prompts investors to lower their allocations to higher-risk stocks/equities.
Smaller companies, and companies focused on future growth, are especially affected by higher inflation. For companies to continue making a profit they need to be able to pass along their Inflated costs to their customers. Larger companies, with strong, loyal customer bases, have a much easier time passing costs along. But smaller companies or high-growth businesses often struggle with heavy competition and are only beginning to establish a loyal customer base.
Inflation plays an important role when analysts try to calculate a present valuation based on a company’s future cash flows. In order to estimate a current company valuation, analysts calculate the value using a discount rate. The calculation requires a multitude of estimations on revenue growth and margins, and then it discounts the risk associated with each company. Once all those calculations are made, inflation must be added to the discount rate. The value of $100 dollars today does not hold the same value of $100 dollars in five years’ time. The higher inflation expectations are, the less that $100 dollars will be worth in five years. So, when calculating a current value on a future cash flow, in addition to risk contributing to the discount rate, inflation also plays an integral role. With all this in mind companies that are primarily expecting to make profits in the future – as opposed to companies that are generating current cash flow – are greatly impacted by inflation.
All investments have a risk-reward ratio; there is no reward without risk. Generally, the higher the reward, the more risk you will need to bear. Good short-term performance is not hard to accomplish, but replicating that performance is the hard part. An investor would need to have a perfect understanding of the how’s and why’s of his short-term outperformance before attempting to replicate his model – an almost impossible task.
At the beginning of 2021, a friend of mine asked me why he should invest with a professionally diversified portfolio when, “My account is up 110% since Covid. I’ve invested in a handful of growth companies .” His assessment was followed by a substantial drop in small caps and growth stocks, leaving his healthy account bruised and diminished.
Managing your investments on your own can work well in the short term but keeping performance riding high in the long run is where things get tough. At Equinum, we’re here to help you with that. Contact us at [email protected].