Runaway Inflation? If So, These Are The Stocks To Buy

Summary

• The US is still restraining the supply of essential goods via tariffs and Covid restrictions while printing money for stimulus. This is a recipe for inflation.
• A look at which sectors perform best (and worst) in inflation and rising rates.
• Some negatively correlated ideas that can help your portfolio.

Inflation is like toothpaste– once it's out, you can hardly get it back in again.

-Karl Otto Pohl, German-Swiss economist, 1929-2014.

Federal Reserve chairman Jerome Powell fielded a lot of questions on inflation in his semi-annual testimony to Congress in Washington DC last week. He acknowledged that the inflation rate would be "volatile," but did not see the changes being large or persistent. Meanwhile, at home in Texas, I've seen intermittent shortages of items as disparate as bottled water, used cars, ammunition, appliances, lumber, precious metals, computer chips, and dress shoes. Oil prices are already back above $60 per barrel while the Federal government takes steps to restrain oil production. It's almost a perfect storm for inflation.

The US government could be about to make a classic macroeconomic blunder here, which I'll explain below.

Most economic recessions come when aggregate demand falls from people losing jobs, debt coming due, etc. Examples of this include 2008 and the Great Depression of the 1930s. However, a drop in the American public's standard of living can also come when aggregate supply shrinks. The most commonly cited example of this is the oil shocks of the 1970s and the ensuing recessions. Economists refer to this kind of event as a "supply shock," and the resulting inflation as "cost-push inflation." Together, they can create stagflation, which is extremely expensive and difficult to get rid of once it begins. If it's allowed to happen, stagflation will create totally avoidable misery for millions of people.

Cost-push inflation (stagflation)

Source: Wikipedia

I'll help you interpret the above graph really quickly, with cars as an example. At the beginning of 2020, we were at the intersection of point Y and point P, which is a balanced market.

Unlike other sectors like travel and entertainment, demand for cars has been stable throughout the pandemic, while supply has been affected by factory shutdowns and shortages of semiconductors, which they need to make cars. Now, with demand unchanged, cars become more expensive and there's less to choose from, putting us at the intersection of point Y1 and P1. From the perspective of the automobile market, everyone is worse off than they were at the beginning of 2020 – automakers can't sell as many cars and consumers have fewer choices. In fact, with ongoing semiconductor shortages, the aggregate supply line for cars is becoming increasingly vertical, meaning that even if demand grows for cars, automakers are going to struggle to produce them because they don't have the components they need. There are three kinds of economic policy, left, right, and stupid. The trick for a well-run democracy is to pick economic policies from the first two categories and avoid the third.

Now let's say the government decides this is a crisis and hands out stimulus vouchers for consumers to purchase cars. Because supply is relatively fixed by shortages from auto components and ongoing restrictions on economic activity, all the government would do is raise the price of cars without doing anything to increase the welfare of consumers. To this point, if you live in a city with rent control, have a good job, and can't buy a house, this is why. Government intervention that interferes with economic activity will always create supply-driven shortages and surpluses when incorrectly calculated.

This is a simplified example, but for this reason, it's a classic policy mistake to cut interest rates or do excessive amounts of stimulus into a supply shock, much like treating an infection with the exact wrong kind of antibiotic. You see this a lot in Latin America and other areas of the world that have their monetary policy set by politicians rather than independent central banks. The governments there will often give election-year stimulus to help them get re-elected, which is politically popular but doesn't solve any economic problems and causes inflation. The US made a version of this mistake in the 1970s, which exacerbated widespread shortages and caused the inflationary mess that we got ourselves into then.

Unfortunately, with the US government hell-bent on issuing more stimulus without doing much of anything to address supply issues, the legacy of more and more stimulus is going to be $4 gas and double-digit annual rent increases for middle-class America. They've (mostly) gotten away with printing money so far, but this is not the kind of thing you can do in perpetuity, or even for multiple years in a row without unpleasant consequences. The opposite of this is true if society manages to increase aggregate supply. Everyone is better off if there is an abundance of high-quality, cheap goods. For example, prices of computers, TVs, and smartphones have fallen in real terms over time, and consumers have gotten better and better choices over time.

I'm not going to sugarcoat it, these shortages are in large part the fault of politicians. If the government really wanted to increase welfare, they would temporarily drop punitive tariffs on goods like Canadian lumber and Chinese semiconductors, reverse trying to restrain domestic oil production, stop coronavirus restrictions on factories, and let the free market do its job. I'm not getting my hopes up though. My fear is that politicians would rather get re-elected with $4 dollar gas, more shortages, and shrink the middle class than do the right thing in the long run if it's politically unpopular.

What stocks do well in inflation? What stocks do well when real interest rates rise?

Now that I've probably scared you a little bit, I'll show how you can sidestep some of these problems in your investment portfolio. This is a graph of the correlation between industry stock returns and inflation. On the X-axis you have the correlation between industry returns and rising or falling interest rates, and on the Y-axis you have the correlation between industry returns and rising or falling inflation. As an aside, my research and real-life experience have found that this kind of mean-variance optimization leads to making more money in the markets with less stress. If you don't have much of an opinion on inflation or rates, you can use this as a rough guide to balancing your portfolio so that changes in interest rates or inflation affect you less. The most negatively correlated asset pairs with respect to changes in rates and inflation include banks and real estate (who often are on opposite sides of the same transactions), utilities and energy (often on opposite sides of the same transaction and business models that balance each other out), and defensive stocks like tobacco, grocery stores, and healthcare paired with cyclical sectors. Other negative correlations you can use for portfolio balance are between corporate bonds and stocks and government bonds and precious metals. These pairings can diversify you much better than, say, owning 100 different tech stocks.

Source: Federal Reserve Bank via Goldman Sachs Asset Management

Best stocks for inflation

1. Energy. The US imports a lot of oil and it's priced in US dollars, so if politicians print tons of dollars and the amount of oil in the ground stays the same, then oil prices go up. Printing money doesn't create wealth, so the consequence of $5 trillion+ in stimulus and a continued lack of macroeconomic understanding could well be $4 gas, coast to coast. LIFO accounting also provides a big tax boost for oil companies in inflation. Rates have little effect on the energy sector.

2. Banks. This one is a little counterintuitive to me, but banks learned their lesson from the large changes in interest rates and inflation in the 1970s so that their loans are generally variable rate, while a large portion of their deposits generally pay zero, since that's what customers are accustomed to. Short-term interest rates tend to correlate with inflation, thus compensating banks. Banks (and oil companies) tend to have low PE multiples too, which means that investors don't have to wait very long to get cash flow that the banks can reinvest at higher rates.

Worst stocks for inflation

1. Utilities – political pressure would likely result in a lot of utilities having to eat some of the increase in energy costs rather than pass it straight to consumers. We live in a low-yield world as well, but this could change, so I'd expect PE multiples to shrink for utilities.

2. REITs (with caveats) – The graph belies just how exposed some REITs are to inflation when they have long lease terms. I invest a lot of my REIT money in inflation-neutral sectors like multifamily apartments and self-storage, which aren't as sensitive to inflation shocks but have similar or better upside to retail and office REITs.

3. Consumer staples – Inflation is thought to be hard on the poor and retirees, meaning that when prices shoot up faster than wages, people will do without rather than pay increased prices.

Best stocks for rising rates

1. Banks. Any company with interest income is going to see an increase in their earnings when interest rates rise. Banks have the most interest income of any sector, so they have the highest correlation.

2. Diversified financials. This extends to companies like stock brokerages, payment processors, BDCs, and anyone who holds cash that they can earn interest on as part of their business model.

3. Insurance companies earn premiums that they can invest so when rates rise, life is good for them.

Worst stocks for rising rates

1. Highly indebted companies. The worst companies to invest in when rates rise are the ones that have the most debt. There isn't anything magical about this, but investors should be careful about owning highly leveraged companies if rates rise.

2. REITs (with caveats). For the wrong kind of REIT, commercial mortgages are often short-term and/or variable in rate, while leases are often fixed. This is a business model that works great in times of falling rates but one that can get you in tons of trouble when rates rise.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.