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The Risk Most Equity Investors Ignore at Their Own Peril

The Risk Most Equity Investors Ignore at Their Own Peril
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By Friday, 07 August 2020 12:46 PM Current | Bio | Archive

Investors focused on the short term are ignoring a major risk lurking on the horizon.

Although the current recession is causing temporary deflation, the combination of deglobalization and record fiscal stimulus could ignite inflationary pressures in the near future. Inflation typically leads to declining earnings multiples.

With valuations near record highs, the typical equity investor is not prepared. Long term investors need to use new tools to navigate this new environment.

Supply Disruptions

The supply side factors that kept inflation low for decades are beginning to reverse. Over the past few decades, globalization ensured a steady supply of low-cost labor, and cheap goods. The fall of the Soviet Union and China’s entrance into the WTO brought large, previously isolated populations into the global labor force. Multinational companies searched around the world for the country where they could manufacture goods at the lowest possible cost. This labor arbitrage kept inflation low.

We are now in the early stages of a deglobalization. It started with the election of populist leaders around the world, most notably President Trump in the United States, and has been accelerated by COVID-19. Trump is pursuing an “America First” Policy. China is increasingly turning inward, as evidenced by their plan to promote local innovation. US and European defense officials are increasingly concerned about dependence on China for key medical and technology products.

In the wake of COVID-19 countries around the world-imposed export bans on a variety of products, leading to supply shortages. Integration will not completely reverse, but even a partial decoupling has major consequences for supply chains.

Going forward, supply chain decisions will no longer be focused on finding the lowest cost. Instead companies will focus on resiliency and take political risk into account when making sourcing decisions.

Many companies will build networks of alternate suppliers and or focus on domestic production. This will make industries less susceptible to future shocks, but will also increase cost structures. Additionally, companies operating within the United States will face higher labor costs due to immigration restriction.

Record Stimulus

As companies begin to face higher cost structures, governments around the world have responded to the COVID-19 crisis with unprecedented stimulus. This year alone, the Fed balance sheet has already expanded by more than it did in the four years following the 2008 global financial crisis. Fiscal and monetary policy have traditionally been kept separate, but are now hopelessly intertwined. Under the CARES act, the Treasury has capitalized a special purpose vehicle which the Federal Reserve can leverage 10 to 1. Central bank independence died of COVID-19.

After the previous global financial crisis government stimulus was primarily targeted at financial markets, not households. However, now policymakers are aggressively targeting household income with direct transfers that in aggregate more than compensate for temporary demand destruction

. Consequently, we are likely to face inflation not just in financial assets, but also in the real economy. As society reopens, this record stimulus will amplify previously pent up consumer demand entering a market full of supply disruptions.

We’ve already seen evidence of rising prices for certain consumer essentials such as groceries, even while we are in a steep recession. The slightest bit of recovery will turn inflation into a serious concern. When inflation expectations tick up, they can quickly get out of control.

Investors Are Unprepared

In spite of this inflationary setup, investors are woefully unprepared. Few companies in the S&P 500 stand to benefit from inflation. Many companies will find their revenue cannot keep pace with their costs. A small subset of companies has enough pricing power to grow revenue faster than costs. However, even investing in these companies might not be enough.

History shows that during inflationary periods, such as the 1970s, return on equity across the market fails to keep up with the inflation rate. Consequently, earnings multiply contract when inflation rises. With multiples near record highs, this is a serious risk to a lot of portfolios.

Of course, fixed income investments fare even worse under inflation. So what can investors do?

Investors can buy some mining and resource stocks, but most investors need better diversification. The current environment calls for new investment products, such as earnings derivatives, which allow investors to isolate their investment exposure to earnings and revenue growth of a particular company or industry, without exposure to the risk of a collapse in earnings multiples. Just as the Federal Reserve is using new tools to stimulate the economy, investors should use new tools to protect their wealth.

The coming years will present unique challenges for investors. Investors need to be aware of the inflationary risks and position their portfolios accordingly.

Jacob Mohs is CEO of BLX Global, which develops and licenses innovative financial products and created the Earnings Indexes, tracking earnings performance of FAANG, airlines and banking stocks.

© 2020 Newsmax Finance. All rights reserved.


   
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Investors focused on the short term are ignoring a major risk lurking on the horizon.
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2020-46-07
Friday, 07 August 2020 12:46 PM
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