A stock picker’s guide to inflation

OSCAR PULIDO: With inflation at the highest level in decades and volatility continuing to surge, equity investors are questioning their next moves.

Welcome to The Bid, where we break down what's happening in the markets and explore the forces changing the economy and finance. I'm your host, Oscar Pulido.

Today, I get to welcome back an audience favorite to The Bid, BlackRock's CIO of US Fundamental Equities, Tony DeSpirito. From market winners and losers to underappreciated opportunities, together we'll break down how inflation is impacting the economy and what history can teach us about the outlook for the stock market. 

OSCAR PULIDO: Tony, welcome back to The Bid.

TONY DESPIRITO: Hi, Oscar. How are you?

OSCAR PULIDO: Good. This is fun to do again. So let's talk about the stock market. The first half of the year marked the worst start for the S&P 500 since 1970 and we've seen a lot of volatility in the market. A big reason for this has been that inflation has been a lot higher than people expected. So how do stocks typically do when we're in these periods of high inflation?

TONY DESPIRITO: So let's start by talking about this year and then maybe relate that back to what we've seen historically. At the beginning of the year, financial conditions were very loose by any means historically, and we've very rapidly moved from loose financial conditions to tight financial conditions, and that's had a huge impact on valuations.

OSCAR PULIDO: And is that interest rates? When you say financial conditions, is that one of the ways-- 

TONY DESPIRITO: It's mostly interest rates, but it's broader than that. It's liquidity in the market, it's multiples, it's market enthusiasm, et cetera. So it's a little broader than just rates, but that's definitely a big part of it. And when you think about the Fed, towards the end of the last year the Fed was still saying inflation is transitory, don't worry about it. And now the message from the Fed is completely different. It's, inflation is our number one problem and we're on it and we're going to fight it and even if that means risking a recession. And so you really see how the pendulum has swung when it comes to monetary policy. And if you look at the market, earnings have actually been creeping upwards. So earnings have been quite healthy. What's been the pain point has been multiples. That's a huge change. So now let's look at the historical context. Inflation is painful and challenging all around. It's certainly painful and challenging for consumers. They have to stretch their dollar further. That's tough on consumers, particularly lower end consumers where things like energy and food are a higher proportion of their income. It's also tough for bond investors. The coupon payment is typically fixed in nominal terms. That's why they call it fixed income. And what that means is those coupon payments buy you less in terms of real dollars as inflation goes up. It's also challenging for equities, but when you think about corporate revenues, profits, dividends, they actually go up with inflation. So rising inflation actually benefits those numbers. The challenge for equity investors is on multiples. Rising inflation usually means rising rates, which it has meant this year. And rising rates usually means falling multiples, and you've seen it this year. What's unique about this year in a historical context is the speed and the size of that change has been very dramatic. Now inflation doesn't treat all stocks alike. It's typically tougher on growth stocks than it is on value stocks. That's what we saw in the '70s. That's what we're seeing this year. So I think that really sets the historical context for what we're seeing.

OSCAR PULIDO: And you're talking about multiples, so which is really just a way of thinking about the valuation of the stock market. And you've mentioned they've come down because stock prices have come down, but earnings remain pretty solid.

TONY DESPIRITO: So we're definitely keeping an eye on earnings. But I do think valuations are very important when it comes to forward-looking returns for the stock market. I like to say starting points matter. Now, if you look at PE multiples, they're not very predictive of near-term returns, certainly not over the next 12 months. So in that sense, a change in valuation doesn't matter for what you'd expect from stock prices for the next 12 months. But as you look further out, 3 years, 5 years, 10 years. The further out you look, the more predictive multiples are of stock price returns. So lower multiples, better future returns. And so I do think this presents a better buying opportunity for long-term investors. So as long as you're patient and you can withstand the market volatility that we're seeing, I do think the buying opportunity today is better than it was six months ago. 

OSCAR PULIDO: And that long-term investor could be somebody saving in their 401(k) and their retirement plan and therefore the starting point matters.

TONY DESPIRITO: Yeah, absolutely. I mean, think about your time horizon. If you're investing for your retirement depending on your age, that could be for the next 10, 20, 30 years. Certainly that qualifies as a long-term investor, and this would be a buying opportunity for someone like that.

OSCAR PULIDO: You also talked about value stocks and growth stocks a little while ago. So growth stocks, I think, of the big tech companies that were the real focus of, really, the last couple of years, generating great growth in a period where we were living through a pandemic. And I think of value stocks as like the older economy, the industrial plant, the energy company paying dividends. I'm kind of generalizing here. But when you think about those two different camps of the stock market, where do you see the opportunities? Are you seeing differences between the growth stock camp and the value stock camp?

TONY DESPIRITO: Yeah, we're seeing big differences in returns this year. And if you, again, look at a history lesson, a post global financial crisis, we had very slow growth, lots of slack in the economy, unemployment was high for an extended period of time. That meant inflation and rates were low along with slow growth. That's a great environment for growth stock investing. The discount rate is low, growth stocks benefit from that low discount rate. Growth is hard to find. And so when you think about supply-demand for growth stocks, there's a lot of demand for growth stocks relative to the supply. So it's a good environment for growth stocks. That got accelerated by the pandemic. As you point out, many of the growth stocks are tech in orientation. And in that low contact world, tech stocks were definitely-- the earnings power of those stocks was accelerated, meanwhile interest rates went even lower. That was a great period. What we saw, though, is valuation spreads started to really widen. It's just how wide is that discount. That discount got abnormally wide. And at the same time, we started to see inflation. And inflation is certainly good typically for value stocks, as we discussed, and at the same time you saw a little bit of a COVID hangover, I'll call it, some rebound effect on some of those growth tech stocks. So in that sense, this recent environment has been very good for value investors. And when you look at history, value stocks tend to do well in periods of inflation and rising rates, et cetera.

OSCAR PULIDO: And so you mentioned value stocks do well in periods of rising inflation. So when it comes back to stock market investing, is there a difference between how you build an inflation-proof portfolio versus how you build a recession-proof portfolio, or are those kind of the same things?

TONY DESPIRITO: No, they're very different actually, and that's one of the challenges for investors. So if you think about the Fed, the Fed's in a tough spot. Obviously they're trying to slow the economy just enough to slow inflation without creating a recession. That's the goal. A soft landing so to speak. But tighten too little and then you risk inflation spiraling out of control, like the '70s, tighten too much and you risk a recession. So what's an investor to do? When I think of the barbell, I think, on one hand, of cyclicals. That's the risky part that will benefit from inflation. I think about companies like energy stocks. Clearly there's a supply-demand mismatch that's part of the inflationary story. Energy companies benefit from that. I think about financials. It's one of the few sectors that actually benefit from rising rates. I'm also increasingly thinking about select opportunities in consumer discretionary. The fears of tightening, the fears of recession have definitely beaten up a number of consumer discretionary stocks. They've gotten incrementally cheaper, so I would put in that part of the barbell as well. On the other end of the barbell is the recession fighters. And there I favor health care stocks. I think that's a very attractive sector. I think about defense companies. And also, in the portfolios I run, we've been running a little bit of a cash reserve as well on that end of the barbell. And then, of course, we're fundamental stock pickers, and when a market moves this quickly, this rapidly, inevitably the babies get thrown out with the bathwater. And so there are a lot of opportunities for folks like myself in fundamental equities where we're active stock pickers to sort through the wreckage and find some really good stock-specific unique opportunities.

OSCAR PULIDO: I'm just curious, when the inflation narrative started to take over, when we went from not worrying about it a year ago to now it's the only thing we talk about, were there any changes in sector performance in the stock market that were unexpected?

TONY DESPIRITO: So one of the things that I task my team with doing is really going back and do a historical study of the period that the Fed calls the ‘Great Inflation” which really started in the late '60s and went all the way to the early 80s. And there were clear winners in that environment. Energy was number one, financials number two, health care number three. We've largely seen that pattern here again. And then on the flip side, growth stocks were hurt.

OSCAR PULIDO: Let's focus maybe a bit on the underappreciated sectors.

TONY DESPIRITO:I think energy had been left for dead. We all know we're transitioning to a lower carbon environment, but it's going to take time. And in the interim, there's still a lot of cash flows to be had in the energy sector, particularly from companies that are transitioning in a smart, economically productive way. So that's something maybe investors forgot about. Health care, I think, is particularly interesting. We talked about the portfolio you want in an inflationary environment versus a recessionary environment. Interestingly, I think health care fits the bill in both cases. It's one of the few, if not the only sector, I think, that really does that. 

OSCAR PULIDO: Right. You're going to get sick in a recession or if times are good, there's going to be demand --

TONY DESPIRITO: You still have to spend on your doctor. What's interesting to me there is-- obviously, I think it'll be more recession resilient than in the past, and that's because government has become a larger percentage of health care payments. A higher percentage of people are in the Medicaid rolls, on the Medicare rolls, or receiving subsidies for the exchanges than in prior recessions. In fact, exchanges didn't exist in prior recessions. So I think health care will prove to be even more recession resilient this time.

OSCAR PULIDO: I think a big part of why inflation has gone up is because the economy was restarting. We talked about, hey, we're in person, we're doing this live and COVID is slowly kind of receding, people are coming back to the office, the economy is opening up. That's what's caused inflation to increase, because we had these bottlenecks in the supply chain. So, is inflation now actually going to recede to the background? Is this a short-term phenomenon, or do you think inflation is going to be more persistent over a longer period of time?

TONY DESPIRITO: So it's both. So without a doubt, you're right. The stop, start nature of COVID has definitely resulted in big supply bottlenecks, and that's led to a lot of the inflation we've seen. But we did have big stimulus, both in terms of fiscal and monetary policy, with hindsight, probably more than we needed. Now, I think inflation is-- we're probably getting pretty close to the peak in terms of inflation. We're going to start to see it come down partly because of both fiscal and monetary policy are tightening partially just because those supply bottlenecks will start to ease. And so without a doubt, we're going to come down from these high levels. The question in my mind is, but what level do we come down to? And I do think that there are some real long-term inflationary pressures that we as investors need to be aware of. The biggest of which revolves around globalization. If you think about the last 40 years, globalization has had a huge disinflationary impact on the economy. Mostly China in terms of China really becoming an industrial powerhouse, a manufacturer for the world. That's been hugely disinflationary. But that's largely run its course. In fact, now the labor age population in China is actually starting to shrink. And then there's some powerful forces towards deglobalization that we're starting to see. Some of it relates back to the trade war under the Trump administration, certainly COVID highlighted the need. Historically supply chains were built for efficiency. COVID really highlighted the need more for resiliency of supply chains. And then certainly with what's going on with Russia and the Ukraine, that also highlights that need of reshoring. And so that's what we're starting to see, is the trend is away from globalization to reshoring. Without a doubt, that's inflationary.

OSCAR PULIDO: And just efficiency versus resiliency. So supply chains were built for efficiency in the past. That meant--

TONY DESPIRITO: Lowest cost--

OSCAR PULIDO: Lowest cost.

TONY DESPIRITO: Wherever it was.

OSCAR PULIDO: Resilience is now I can get it quick, and I might have to hire more expensive labor, but it's closer to home, and I'll have my good or service quicker.

TONY DESPIRITO: Exactly.

OSCAR PULIDO: And that's what you mean by-- that's one of the manifestations of deglobalization.

TONY DESPIRITO: Exactly. And so I think that's a big trend. Also, if you think about decarbonization, that's also going to be costly, because for a period of time we're going to have to run two energy sources. We're going to have to invest in renewables at the same time that we maintain a certain amount of old fossil fuel. I think ultimately in the long run that can be deflationary, but that's a long way off before we get there. And during the building process, that's going to be inflationary. It's going to add to costs running these dual systems. And then finally, just demographics. The aging of the population, the slowing of immigration, that's also inflationary. And so you put those three things together, I don't see us going back to the ultra low levels of inflation we saw post global financial crisis. So sum it up, we're coming down from these high levels, but we're going to end up somewhere higher than we were certainly over the last 10 years.

OSCAR PULIDO: And we've been talking about globalization and deglobalization and just what's going on outside the US. So is inflation a similar concern in many other international markets?

TONY DESPIRITO: Oh, absolutely. It's a concern almost everywhere around the globe, except maybe China, which has some of its own issues with COVID. And so if you look around the globe, start with emerging markets, there's where inflation is most concerning. Remember, the items that have inflated the most are food and energy. And when you think about emerging markets, consumers in emerging markets are spending a higher percentage of their total disposable income on those things. And so they're really feeling quite pinched from a GDP and consumption perspective. So I think inflation's a real struggle for emerging markets. If you look at around the world at other developed markets, certainly the US is unique amongst developed markets in terms of the degree of our energy self-sufficiency, which is really helpful in this time of high oil prices. So Japan and particularly Europe are struggling with energy. Europe, particularly because of the dependence on Russian natural gas, and so you're actually seeing the possibility of having energy shortages and rationing going on later this year in Europe. And so when I think across the developing-- the world, the US is really the best house in a tough, tough neighborhood in that sense. And that's why you've seen the dollar be as strong as it has been this year.

OSCAR PULIDO: And so inflation is really a global phenomenon with maybe some exceptions. But your view is that stocks-- but specifically certain areas of the stock market can be a good way for investors to try and position themselves for a higher inflation environment.

TONY DESPIRITO: Exactly.

OSCAR PULIDO: And of course, if we head into a recessionary environment, those dynamics might change a bit, but stocks ultimately can provide some protection against inflation if you're in the right areas.

TONY DESPIRITO: Right.

OSCAR PULIDO: Yeah, yeah. Maybe one last question, which is it's been, I think, tough for people to be an observer of the stock market this year. It's sort of we got out of the gates on that footing and we've kind of been trending down for much of the first half of the year. But what's it just like for you? You've been a stock market investor for a number of years. Are these fun periods for you when you get lower stock prices? Or is it equally as tough to be an investor as it is an observer?

TONY DESPIRITO: So I think it's always tough to be an investor, actually, but it helps to really take that long-term perspective, and it helps to have a historical perspective. And the market we're in right now is a good reminder that stocks don't always just go up, that there's volatility, that volatility cuts both ways. But as an equity investor, you shouldn't really be thinking about the next three months, six months, next year even. You should be thinking about the next 3, to 5, to 10 years, and that's the perspective you need to bring. And it really helps in markets like these when you have that perspective. And obviously, it's been emotionally difficult because there's been a lot of pain, there have been a lot of losses. And so that's hard for all of us, both professional investors as well as our clients. But there's also some excitement to be had. The fact that we've seen a lot of stock dispersion. And that means there's a lot of opportunity out there as well. And so while it can be tough emotionally, it's also a time of optimism and excitement, and that's what I see across our team.

OSCAR PULIDO: Well, thank you for the historical perspective that you've provided, and I'm sure it's going to serve you well here as we go through the rest of the year and then in the years ahead. Tony, thanks again for joining us on The Bid.

TONY DESPIRITO: Thank you, Oscar. My pleasure.

OSCAR PULIDO: Thanks for listening to this episode of The Bid. For more insights on the future of the market, check out our last episode, The Mid-year Outlook.