September 13, 2021

Inflation

Rick Bookstaber

By Rick Bookstaber

Co-Founder & Head of Risk

How do you explain inflation to your clients? Are there steps to protect a portfolio? If you are reading the inflation effect off of some bar chart, you are missing the essence of inflation risk. Risk factors are the way to go.

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Here is my sense of what factors to worry about — and what to key in on to benefit from, or at least buffer, inflation’s effects.

The point is that some factors will do better than others, and a portfolio constructed around those will likely do better as well. This is not about stocks directly, because different stocks will have different loadings on the critical factors.

First, the broad scale effects:

Interest rates, obviously, go up.

Credit spreads widen. More stress for some companies that can’t pass through costs, and spreads widen when interest rates rise.

Now the factor effects:

Companies with high leverage will be in the negative territory. Leverage looks at long-term debt, but we can assume a need to roll it, and it will be done at a higher cost, both due to rates and credit spreads.

Size is a positive. Higher size means more market power, and so costs can be kept down, and in some cases price can be raised. Low size means cost takers. So hurt more.

Value is a negative. This is a little iffy. My argument is that value often means brick and mortar, and a cost structure wedded to real factors of production. By contrast, high growth tends to be biased toward companies driven by intangibles.

Some argue that growth is hurt because high rates discount earnings further out. But (a) inflation effects are not expected to persist long-term, and (b) although Finance 101's dividend discount model counts the present value of distant earnings, the reality is that investors don’t really think about longer-term earnings because they know anything can happen between now and then.

Emerging markets is a positive. Another bit of a reach. But EM tend to be commodity producers, and the ultimate end of the supply chain is insulated from inflation.

For the same reason, basic material sectors are a positive. So Materials, chemicals. They can change prices.

Intangibles is a positive. So Information technology. They do not have as much in terms of “real” costs.


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