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When a consulting firm starts talking inflation, you know a big issue is at hand. The chart below is from a recent Mckinsey note. It makes an interesting point, which investors often miss.

(Click to enlarge)

In inflationay times, companies will often tell analysts, "We will be able to pass on costs, so there is no reason to worry about inflation." Mckinsey points out, "Maintaining reported net profits is not enough. You need to maintain cash flow stream, and that will likely mean that RoE needs to go up. Or roughly speaking, the gap between inflation and RoE needs to be maintained."

So ask yourself this question – Inflation has shot up by say 1000 basis points, or 10% in India (never mind official WPI data). So have corporate RoEs gone up by the same amount?

This almost never happens, as Mckinsey’s chart for US points out. Corporate RoEs dont swing by that much, and certainly not at times of high inflation. No amount of belt tightening can generate that response for entire listed corporate sector.

So at least some, or quite a few companies will suffer. The US markets were flat for much of the decade of ’70s and early ’80s when inflation was high.

A note from Nomura (NYSE:NMR) points out how Indian markets tend to fall sharply whenever WPI has crossed 8% in the last decade. It says – only a matter of time, and ‘when’ not ‘if’ – the markets will react to inflation. They already are reacting, but at least another 10-15% further down from here is needed as a decent response to high inflation.

The graph below shows inflation versus market performance:


(Click to enlarge)

A correction is welcome. Valuations are too high for most companies.

Disclosure: No positions

Source: Inflation in India– Can’t Ignore It Anymore