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President Biden’s desire to “go big” on spending has instilled big fears in some investors.
They’re worried too much stimulus will spark excessive inflation, which can hurt stocks in three ways.
1. If companies can’t pass along rising costs, margins and profit growth crumbles.
2. If they do pass on rising costs to customers, widespread inflation can make the Federal Reserve tighten monetary policy — a main cause of bear markets.
3. If neither happens, rising inflation can lead to higher bond yields. As a result, fixed income as an asset class becomes more attractive. And rising rates erode the present value of future earnings. Valuation models must then use a higher discount rate, typically the 10-year Treasury yield, which has already doubled in the past few months.
Don’t brush off the fear of inflation. But be mindful of three other powerful forces that will negate pressure on higher prices — more on that below, along with stocks that stand to perform well this year.
Where inflation fears come from
Inflation is a bigger risk than you might think now, because inventories are the lowest since 2009. The sharp pickup in economic growth ahead — it might reach 8.5% in the second quarter, says Goldman Sachs — could propel prices as buyers scramble for scarce goods.
You already know about this if you’ve recently bought appliances, and household paper and cleaning products. Prices are up 9%-23% compared to a year ago.
Likewise, tech companies face chip shortages.
“With virtually no inventory and some of the fastest growth in decades, price inflation could certainly rise,” says Jim Paulsen, chief market strategist at Leuthold Group.
Given all of this, it’s no surprise Ed Yardeni of Yardeni Research says the biggest concern among investors in client Zoom calls is inflation from “excessively stimulative fiscal and monetary policies.” A recent Deutsche Bank survey of clients confirms this.
But everyone needs to just calm down about inflation for a simple reason. No, not technology, trade or the aging of the population — the commonly cited factors keeping a lid on prices. Those are valid.
Instead, three other factors will save stocks from the perils of inflation.
1. Productivity to the rescue
This is the big one. Covid-19 has compressed years’ worth of tech adoption into one year, to paraphrase Microsoft MSFT, -1.16% CEO Satya Nadella. This means we’re about to see the biggest productivity boom in 20 years. Productivity is the great inflation killer.
Why? Because it neutralizes the impact of rising costs for inputs like raw materials among manufacturers and food producers, and for labor (the $15 minimum wage continues to gain traction).
When productivity is rising, companies can squeeze more products or services out of the same amount of labor. So they don’t have to pass along higher costs to their customers. Upstream inflation is stopped in its tracks.
Despite what your intuition may tell you, productivity isn’t about people working harder. It’s about companies spending more on capital goods like technology, software and machines, relative to employees. This helps workers get more done in the same amount of time.
Companies, such as Microsoft, are telling us tech adoption hit warp speed during the pandemic. A recent McKinsey survey confirmed that companies sped up the adoption of digital technologies by several years. “Respondents expect most of these changes to be long-lasting and are already making the kinds of investments that all but ensure they will stick,” says McKinsey.
We see it in the big-picture data, too. Capital spending (non-defense capital-goods orders excluding aircraft) went to new highs during pandemic, says Paulsen. “That’s a really good sign for productivity.”
This isn’t just about Zoom ZM, -0.16% calls and Microsoft Teams meetings cutting down on the cost of travel and office space, though that’s a big part of it.
Consider these huge changes, too.
Covid-19 has forced companies to interact with customers more often through digital channels, streamlining sales and customer support. The pandemic has sped up the use of robots for deliveries, contactless payment and telehealth.
Behind the scenes, companies are streamlining supply chains by deploying more tech like robotics and 3D printing. They’re using more “internet of things” connected devices and artificial intelligence for better insights on production trends.
“The COVID crisis seems to be acting as a massive accelerator for the adoption of new technology, forcing companies to reexamine their entire production process — from the sourcing for materials and parts to end-market delivery,” says William Blair strategist Richard de Chazal.
You can see this in the solid performance last year of web-content and business-app development stocks like Fastly FSLY, +0.60% and Appian APPN, -5.90% ; 3D printing stocks like Materialise MTLS, +2.85% and Proto Labs PRLB, -0.41% ; and automation, internet of things and robotics plays like Alarm.com ALRM, +1.64%, Analog Devices ADI, +3.61%, Rockwell Automation ROK, +1.65% and Honeywell International HON, +0.02%.
2. Greater workforce participation
Covid-19 has trained companies and workers to be more flexible, points out de Chazal. “This in turn will hopefully play an important role in increasing labor force participation, and thus labor force growth.”
This could relieve inflation pressures since it means less upward pressure on wages — wage hikes that would need to be passed along. Economists at Goldman Sachs predict the labor force won’t be tight enough to spark wage inflation until 2025, at the earliest.
3. Survival of the fittest
A lot of great companies in retail, dining and entertainment have no doubt been forever put out of business by Covid-19. This is a real shame. But the pandemic has also forced a lot of less productive companies out of business, which should boost overall productivity, says Goldman Sachs.
Investing takeaways
1. Don’t sell long-term positions because 2021 should be a solid year for the economy and the markets.
Despite the current worries about inflation, productivity gains will keep it from rising so much that the Fed has to raise interest rates soon. Goldman Sachs economist Jan Hatzius predicts the Fed won’t start tapering asset purchases this year. The bull market is far from over. It does make sense to be a little cautious in the near term because sentiment is high and insiders are cautious. Also remember that 10% pullbacks can happen at any time.
2. Expect higher growth for longer.
“The COVID pandemic has been a forced experiment [in technology adoption] that ultimately could result in higher real potential GDP growth, which has significant implications for longer-term growth,” says de Chazal, at William Blair. The rebound in jobs growth that will happen soon, along with the decline in Covid-19 cases as vaccines and infections boost herd immunity, will also unleash a big wave of consumer spending. They’ve been stashing away money in savings accounts, so they have a lot of firepower. So do companies. S&P 500 companies have boosted cash levels to over $2 trillion from around $1.6 trillion at the start of the pandemic.
3. Favor reopening plays, cyclicals and companies that benefit from a steepening yield curve.
In my stock letter, Brush Up on Stocks (link is in the bio, below), I’ve been favoring reopening plays since March of last year when they really got hammered. They’ve doubled or more, but I still like them, and I am not selling. Favorites I have singled out include Carnival Cruise CCL, +7.43%, Churchill Downs CHDN, +1.82%, Safehold SAFE, -0.06% in office space and Red Rock Resorts RRR, +1.88% in gaming.
Carnival Cruise recently said advance bookings for the second half of 2021 are near historical highs, and bookings for the first half of 2022 are ahead of the same time frame in 2019. (That is, with minimal advertising and marketing.) Disney DIS, +0.36% CEO Bob Chapek recently said progress on vaccine distribution over the next two months will be a game changer that could “accelerate our expectations and give people the confidence that they need to come back to the parks.”
I’ve also been suggesting cyclical and industrial names, because those do well during transitions from recession to rapid growth. In this group, I’ve recently suggested Teledyne Technologies TDY, -0.64% in digital-imaging sensors and industrial monitoring instruments at around $388, and Greenbrier GBX, +2.75% in railroad cars around current levels.
Finally, I continue to like banks and financials as a play on the steepening yield curve, which boosts their profits. A portfolio of six banks I suggested in my stock letter in August was up 45% by the middle of January, compared with 14% for the S&P 500 SPX, -0.19%. In that group, the one that currently looks the most buyable is B. Riley Financial RILY, +7.12%, since at $53 a share it is the one that’s closest to my latest suggested buy limit range ($47.50 to $49).
Michael Brush is a columnist for MarketWatch. At the time of publication, he owned FSLY, APPN, CCL, CHDN, SAFE, RRR and RILY. Brush has suggested FSLY, APPN, ADI, HON, CCL, CHDN, SAFE, RRR, DIS, TDY, GBX and RILY in his stock newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks.
