The Impact of Inflation

June 28, 2018

From the end of 2017 through April, inflation has increased from +2.1% to +2.5% (using CPI as a proxy). Over the same period, the yield on ten-year Treasury bonds has risen from 2.4% to 3.0%. These moves have led market participants to question if a change in the status quo is underway. Let’s assume inflation continues to climb, spurring higher interest rates. What are the implications for investors?

Let’s start with short-term bonds. For these securities, higher interest rates have a limited impact on prices. This is because the coupon on a short-term bond is “renegotiated” frequently. Let’s say you buy a short-term bond and then rates shoot higher. When that bond matures in a few months, you can take the proceeds and reinvest in a security with a higher interest rate that reflects current market conditions (any entity looking to issue debt in that environment will have to offer a higher interest rate to attract capital). Changes in market conditions are reflected in the coupon (interest rate). For this reason, short-term bonds trade in a tight range around par value.

The same logic applies to long-term bonds – but the adjustment factor comes through changes in the price of the bond, not the coupon. As noted above, investors will demand higher yields on bonds when rates rise. But unlike the short-term bond, where the coupon is constantly reset to reflect current market conditions as the bonds mature, the coupons on a long-term bond are fixed; it can be years, or even decades, before they’re “renegotiated” (after the bond matures).

Imagine a thirty-year bond with a 4% coupon. If interest rates start rising, the coupon on our long-term bond will be inadequate. To compete for capital, the yield to maturity on the bond needs to increase; as a result, the price of the bond will need to decline. The magnitude of that decline (all else equal) depends on the duration of the bond: a thirty-year bond will see its price decline significantly more than a three-year bond if rates rise.

In terms of economic substance, stocks are comparable in nature to long-term bonds. What makes them distinct from bonds is the nature of their “coupons”. Most notably, the timing and magnitude of cash flows for an equity investor are uncertain, particularly in the short-term.

Equity investors hold a residual claim on the cash generated by a business. Value depends on the timing and the magnitude of these cash flows. To calculate the value of a business, these future cash flows are discounted back at by some measure (the “discount rate”). Several variables are considered in determining the appropriate discount rate. Interest rates are one of those variables. When interest rates rise, the discount rate increases as well. As a result, the present value of the cash flows declines.

What we’re left with is a lower present value estimate against an unchanged level of current earnings (said differently, the price-to-earnings ratio declines). While it’s impossible to breakout the attribution of market movements to a single variable, we think higher interest rates may have contributed to the contraction in the market’s P/E multiple that we’ve seen so far this year (the forward P/E multiple for the S&P 500 has declined from roughly 18.3x in December to roughly 17.0x today).

Changes in inflation and interest rates can have a meaningful impact on the value of investment securities – particularly stocks and long-term bonds. As Warren Buffett said in a recent interview, “Interest rates are like gravity. If interest rates are zero, values can be almost infinite. On the other hand, if interest rates are extremely high, that’s a huge gravitational pull on values.”

Based on that information, what’s an investor to do? We think part of the solution is investing in high-quality businesses with sustainable competitive advantages. These businesses should not be unduly impacted by inflation because they are ultimately able to pass through input cost increases to customers in the form of higher prices. In addition, we continue to favor bonds with shorter durations in our fixed income portfolios. We do not believe long-term bonds currently provide adequate compensation relative to the level of interest rate risk assumed. Finally, we continue to build balanced portfolios that are diversified across geographies and asset classes.

Time will tell whether we are in the early stages of an inflationary period.  If that’s the case, the P/E multiples investors are willing to pay for stocks may contract further. While there may be short-term volatility, a balanced portfolio with investments in high-quality businesses should do well over time.