Can shares build wealth in a new era of higher inflation?

“I remember the $0.05 hamburger and a $0.40-per-hour minimum wage, so I’ve seen a tremendous amount of inflation in my lifetime. Did it ruin the investment climate? I think not.” 
- Charlie Munger, vice-chairman of Berkshire Hathaway (and long-time associate of Warren Buffett)

There is currently plenty of speculation that we may be entering a new era of higher longer-term inflation and steeper interest rates. Yet, the share market can still be a great place to invest over the long-term, as many companies will continue to innovate and deliver attractive risk-adjusted returns. But investors should take a long-term view, and consider how different business models will adapt to the evolving environment.

A new world order

It is human nature to assume that the future will be like the recent past. This is especially true when it comes to considering our long-term savings.

There are good reasons to think that the ‘great moderation’ is now over. In this 20-year period, investors enjoyed unprecedented low and stable inflation, which gave rise to low and stable interest rates. This helped companies grow earnings and powered stock market returns, boosting the wealth of investors.

But this was not a typical period of history. Some economists now believe that inflation, interest rates and long-term bond yields are likely to be significantly higher over the next decade, than during the last.

Why will inflation be higher?

A number of factors could bring a more volatile global economy, leading to more variable inflation.

The long-term deglobalisation trend, driven by protectionism, economic security considerations and geo-political tensions will likely continue. This will make it harder to import cheaper goods or labour from emerging economies to manage rising costs, as had become the norm in recent years.

More localised supply chains may come at the potential cost of more inflationary pressures. Furthermore, the transition to low carbon energy may result in more volatile prices if the commissioning of renewables does not align with the retirement of legacy assets.

Public expectations of governments are increasing as the world population ages. However, voter reluctance to pay higher taxes for larger states may bring a continued rise in government borrowing, which without productivity gains, risks feeding into higher inflation.

Companies and markets will evolve

Higher inflation pushes up borrowing costs. This will require company management to focus on creating value through innovation and the delivery of internally generated cash flows, rather than borrowing to finance share buybacks, dividend payments or acquisitions.

It may also bring the demise of ‘zombie companies’ that are unable to generate sufficient operating profits to support debt payments at more normal interest rates.

The end of the great moderation brings to a close the power of central banks to support share markets by cutting interest rates at times of market stress – known as the Fed put. This may lead to more volatile share market cycles and increased costs of portfolio protection.

What does this mean for investors?

A structural upward shift in inflation and interest rates is not inevitable, but it is worth investors considering some implications:

1. Be wary of highly leveraged companies, especially those with short-term debt
   
2. Companies able to internally generate the funds required to finance development plans will tend to be more resilient
3. Companies with a compelling market value proposition will be better placed to pass through cost inflation to customers
4. Businesses with a track record of innovation are likely to more consistently grow earnings that compound over time, than those whose returns depend on financial engineering
5. Higher inflation may bring lower real returns, highlighting the importance of early and regular tax efficient saving

Investing in quality growing companies is likely to remain the best way to compound long-term wealth. However, as investors we should think about how the companies and funds in which we invest our savings will adapt to a potentially higher inflationary environment.

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