“I like to compare the Fed’s problem to the challenge of adjusting the shower in an old hotel, where there’s a lag of 20 to 30 seconds between the time you turn the faucet and the time the water temperature changes. It’s very hard to avoid scalding yourself or freezing yourself.” – Larry Summers

This morning’s Core Personal Consumption Expenditures (PCE), the Fed’s preferred inflation gauge, came in 0.2% lower than last month. However, it is still at levels not seen since Paul Volcker walked the halls of the Eccles Building in Washington DC. Mr. Volcker has been invoked lately as the Fed is dealing with inflation comparable to what Mr. Volcker saw during his tenure. He is best known for conquering inflation with massive rate hikes and taking the poison pill of a Fed-induced recession. During his tenure, the Fed Funds rate eclipsed the level (unthinkable today) of 20%. Construction workers used to send him 2x 4x’s with notes inscribed since his unpopular but ultimately successful policy devastated housing demand which hurt construction as well.

Inflation is at levels not seen since the early 1980s. There are many causes of this unfortunate situation. As we might have been getting some relief as the economy normalized compared to the extraordinary situation associated with COVID-19, we got another massive exogenous factor that has proven very inflationary: the Russia/Ukraine War. The inflation from the war is primarily associated with food and commodities. However, some critical metals and materials have been severely interrupted. Energy. though, is the real problematic aspect of the war.  While there was some minor relief in gas prices at the end of this month, there’s reason to believe we could be in for a sustained period of high energy prices.

The old saying is the cure for high energy prices is high energy prices. However, the supply-side shock from the war is being exacerbated by years of underinvestment in upstream production. Energy companies have shifted from investing their money upstream to giving it directly to shareholders via dividends. While this is good if you own the stock, limited supply relative to demand may have a sustained impact.

The other thing is that most Americans don’t buy barrels of oil. In this recent price drop, commodities have declined by 10% to 15% from recent highs, whereas gasoline only declined in the low single digits. Gasoline recently reached the all-time high of $5.03 nationwide. Superficial solutions like knocking off the gas tax or a prominent announcement on production with the Saudis won’t resolve this issue. Many US refineries are already operating at or above 100% capacity, and the refining supply chain has been complicated by the removal of Russian Ural crude for distillates necessary for refining.

One of the problems with gasoline and diesel being so high is that transport costs affect virtually every industry selling something physical. For example, even though many core food commodities have been declining, this might not be able to relieve consumers. In the United States, transport and packaging are the most considerable portion of overall food costs. One thing that might portend continued high energy prices: China is just coming off lockdowns, and demand should normalize there, even if consumers in the US find ways to curtail their spending on gasoline.

Navigating the Inflation Landscape

There are many explanations and correlations that economists use to estimate inflation. We wanted to take you through them briefly and what they imply about the potential course of inflation. You may have heard of the Phillips Curve, which had a “flattening” that was part of the reason for the Fed’s Average Inflation Targeting (AIT) framework. First, we want to explain the difference between two different types of inflation.

–Cost-Push Inflation: Cost-push inflation describes price rises caused by a decrease in the aggregate supply of goods. For example, as commodities and materials necessary for certain types of production go up, the prices tend to be passed onto consumers as companies strive to maintain margins. This type of inflation has become more prominent lately, given the massive supply interruptions and sanctions associated with the war.

–Demand-Pull Inflation: This is the type of inflation prevalent during the pandemic. A rise in aggregate demand causes this type of inflation. Demand-pull inflation can be caused by a heating economy or perhaps new markets being accessible. However, during the pandemic, the massive rise in the demand for goods at the expense of unavailable services was the main driver here.

One of the less complicated inflation models was introduced by Edward Yardeni, and it doesn’t require understanding any advanced economic concepts. He refers to it as the Tolstoy Model of Inflation (War and Peace). Mr. Yardeni showed that throughout history, during wars, prices tend to spike. For example, during the War of 1812, CPI rose 8% and then fell 55% in the period between then and the antebellum. During the American Civil War, CPI rose 70% and then fell 46% from the end of the war until 1895. During World War I, prices rose 70%. They fell 25% from 1918 to 1932. During World War II, they rose 72%, and during the extended Cold War, they rose a staggering 415%. This model may be worth considering as the conflagration in Europe continues to rage.

Mr. Yardeni’s reasoning behind this model is that wars effectively create trade barriers, make labor scarcer, and discourage competition. Wars and conflict mark the opposite of economic integration, and they often lead toward autarky as opposed to global cooperation and trade. The model is an extension of microeconomic thought as opposed to the macroeconomic underpinnings of most models.

Larger markets and global integration result in more cooperation, specialization, lower costs, more efficient supply chains, and a better division of labor. All things being equal, these forces tend to drive down prices and result in a higher degree of innovation and more productivity gains. This model suggests that even if hostilities were to end in Ukraine, the economic and inflationary effects would remain largely the same if the two-way economic siege of the vital commodity-producing belligerents continues.

One other critical model is the Output Gap Model of inflation. This is a demand-pull model that compares the rate of real GDP to what is often referred to as the “potential GDP.” The model primarily relies on analyzing recent trends in labor supply and productivity. The model contends that inflation will likely occur when real GDP or aggregate economic demand is above the gap between real GDP and potential GDP.

Conversely, disinflation or deflation is more likely when demand is below the potential output levels. The Federal Reserve pretty dismally forecasted the inflation rate during COVID-19. Still, the Fed Chair that wasn’t (Larry Summers, quoted above) asserted that inflation would be much higher than all the Fed’s horses and all the Fed’s men suggested. How did he do it? Mr. Summers used the Output Gap method of calculating inflation. “What I saw was a shortfall of payroll incomes of perhaps $30 billion a month compared with fiscal stimulus of $150 billion or even $200 billion a month. I saw the substantial overhand of savings that would be available in 2021.”

The famous Phillips Curve Model of inflation is a cost-push macro model as opposed to the Output Gap Model. The Phillips Curve was observed by A.W.H Phillips using an extensive dataset from 1861 to 1957, which showed that over that time, there had been a conclusive inverse relationship between wage inflation and the unemployment rate. This led many economists to believe managing policy was easier than it perhaps is. The relationship was viewed as ironclad and implied that perhaps the Fed could smoothen the business cycle by managing the right levels of growth, unemployment, and inflation to optimize economic activity. This would set the battle between the Monetarists, who argued such management could only be effective in the short-term, and that the money supply was the most crucial element in managing inflation.

The relationship observed by Phillips appears to have broken down in recent years. The Fed has pursued the price stability mandate with greater efficacy and vigor than in previous years. There is debate about the exact reasoning for the breakdown of this relationship. St. Louis President James Bullard, at least consistently the leading hawk at the Fed, believes the Fed’s management led to more stable and consistent inflation levels.

This led the relationship between labor markets and inflation to break down to much lower than levels observed earlier in the 20^th century. Some others believe that globalization, technology, and the prodigious productivity gains that both result in were the culprit. Either way, as Jay Powell said in 2019 Congressional testimony, the relationship has become weaker and weaker to the point where it’s a faint heartbeat that you can hear now.” The breakdown of the relationship was one of the reasons for the Fed’s now somewhat infamous policy pivot to the Adjustable Inflation Targeting (AIT) framework.

How Does Fundstrat/FSInsight Select Stocks That Will Benefit In an Inflationary Environment?

You might hear some common wisdom about inflationary periods that have been passed down through the generations. One such piece of advice might be to invest in solid assets like Real Estate, which generally tend to appreciate at a pace that keeps up with inflation. Well, this somewhat simple piece of advice can be applied to stocks. How? Well, during periods of inflationary pressure, you can buy asset-heavy companies instead of asset-light. Let’s take, for example, someone relying on subscription revenue. Such a company’s ability to raise prices with the pace of inflation may not be possible, and the inflationary pressure will squeeze margins.

One of our strategic portfolios in Granny Shots is stocks with asset-heavy business models instead of asset-light ones. We focus on companies with high Asset to Sales ratios, High Inventory to Sales ratios, and High Inventory to Assets ratios. In short, the assets of companies with asset-heavy business models provide a natural hedge against inflation. The method also comprises a diverse group of companies.

The other essential item is that we like to pick companies for this portfolio with lower exposure to wage inflation. One of the ways our method keeps out companies with too much capital tied up in their inflation hedging assets is to ensure that their sales growth is occurring faster than their asset growth. You still want profitable companies, not ones that are using capital inefficiently, potentially at the expense of creating economic value for shareholders. Check out our process for selection below.

So, we have observed a lot of data that suggests key episodic drivers of inflation may be coming down. Goods inflation, for instance, should come down as the demand curve normalizes or adjusts from the extraordinary pandemic period and its effects on the economy. However, the war and the unprecedented sanctions associated with it may continue to pressure consumer wallets because of the vital areas it affects.

 Some argue that a reversal of globalization and a movement toward secure supply chains and autarky, often at the expense of efficiency, may result in a secular period of higher inflation. Either way, having some stocks that can weather sustained inflationary pressure in your portfolio probably isn’t a bad idea. Please also keep in mind we are primarily looking at these stocks through the vantage point of being good stocks to own during inflation, relative to companies with more asset-light business models.

Dolby Laboratories, Inc. (DLB0.53% )

This firm is well known for its audio and imaging technologies. It famously was a pioneer in surround sound and entertainment. The company is asset-heavy and has relatively low labor costs. Its sales growth outpaces its asset growth significantly, with a relatively low level of about seven employees per every $1 million of EBIT. The company is an established entertainment name with technical knowledge and a solid and recognizable brand to consumers.

The company is also somewhat of a “picks and shovels” play to the continuing streaming wars without many of the attrition risks that those names face because it is supplying equipment to multiple competitors trying to outspend each other. It serves both content creators and sells directly to consumers, which means its clientele is diversified. Even if consumers are getting sick of streaming, streamers aren’t getting sick of making more and more content yet. The company also has solid pricing power, which is always beneficial in an inflationary environment. Of course, it is still exposed to risks and could suffer if consumers shift their wallets away from the content it facilitates production.

Edison International (EIX-0.04% )

It never hurts to have some names in defensive areas during times like these. Edison International is a major electrical utility primarily operating in California. Edison is very asset-heavy, being an electrical utility. It delivers electricity to around 15 million customers across the Golden State.  The company recently reported a decline in operating income and net income, but this was primarily due to a non-recurring charge. The company has aggressive plans to continue growing and is making a significant investment in expansion, which should be lucrative if the firm executes appropriately over the coming years.

Utilities like Edison International are defensive because they aren’t very susceptible to fluctuations in GDP growth. Utilities are the opposite of cyclical companies. Thus, their revenues and cash flows remain very consistent during a recession. As the economic data continues trickling in and shows weakness, it might not be a bad idea to own some Utes, and this one is a good candidate through the lens of our asset-heavy portfolio. One risk is that the company could be liable for wildfire lawsuits if its equipment has a role in starting fires. As you may have noticed, the state of California has an issue with those things. The company has been devoting considerable resources to ensure it doesn’t start fires. Another risk for Utilities like Edison is that they can be susceptible to high-interest rates as they have high debt expenses.

Cisco Systems (CSCO)

Cisco Systems is a technology stalwart that may not have all the glitz and glamour of some technology names but is an outstanding stock, nonetheless. It provides communications and networking infrastructure across the world. The company also has an extraordinary dividend, which is an excellent hedge against inflation. It has a tremendous backlog and often has long-term contracts, which give revenue relative certainty. The company is highly profitable and has nearly a 30% ROE. The business might be more boring than autonomous driving or quantum computing and won’t necessarily have the growth rates of newer technology peers. Still, it is the right kind of boring: possessing stable cash flows, decent growth rates, high profitability, and the ability to outperform the market going forward consistently.

The company’s pristine credit rating is shifting towards even more consistent subscription revenue. This is the fastest-growing part of the business and has become around 45% of total revenue. The company doesn’t have the highest growth rates, but it is a safe stock for perilous times. It has a large institutional ownership base (almost 75% of outstanding shares) and, because of the digital transformation acceleration caused by COVID, could even be a candidate for some upside surprises in coming quarters. The company’s detractors focus on the fact that they could faceplant on growth goals and generally focus on better places to put your money. This asset-heavy company with stable cash flow is an excellent stock to have in the portfolio, and a dividend yield of over 3.5% is never a bad thing in a stock, particularly when it is exceptionally secure.