I’m slowly building a portfolio in preparation for potential inflation and rising interest rates. The goal is to avoid (obvious) growth and quality stocks, both of which have benefited from low interest rates and led to high valuations (P/E > 20).
Are there others on the forum with the same goal, and what have you picked for your portfolio?
If by quality you mean so-called quality stocks, I’d like to hear how inflation and rising interest rates affect them. I understand that so-called growth stocks would suffer and value stocks would fall less, but if quality companies refer to financially strong, stable-earning firms, how would this scenario affect them?
In answer to the question, gold producers come to mind.
"To me, this is a huge fuss over nothing. The whole correction in tech and other stocks is more about the valuation levels being completely pathetic. They still are, regardless of whether inflation is zero or a couple of percent.
If you genuinely have growth companies that are reasonably priced, they will continue to perform well over the years, even if there’s a valuation cut of a few tens of percentage points.
A classic situation where people are stressing about the wrong things. Better to just focus on the business."
Agreed, guessing the direction of macroeconomics is a zero-sum game. Sometimes you’re right, but usually not.
It’s very difficult to see why inflation would now start to pick up in Europe, considering how anemic it has been for a long time. Especially when you consider that many Southern European countries with their enormous debt burdens probably wouldn’t even survive a 2% interest rate level. At the same time, no painful structural reforms that would serve the long run have been made in the short term. If interest rates rise in the US, it will certainly reflect on us in Europe, but who can really say at this point whether inflation is just temporary or permanent? Only after a few months can one begin to see more clearly what the development path will be.
Inflation may also occur in Europe due to external factors, such as rising raw material prices and product prices from outside the EU, or as a result of exchange rate changes. However, hardly due to internal reasons within the EU area.
Raw material prices are rising, and the latest CPI and PPI figures from the US were higher than expected. Inflation expectations in the US are sharply increasing. Is it possible that inflation could rise due to psychology? Raw materials rise → inflation expectations rise → inflation occurs → inflation expectations rise → inflation accelerates? Powell reiterates in press conferences that inflation is temporary and that stimulus will not be reduced. No one knows if it is permanent or temporary. According to him, the Fed has tools to control inflation if necessary. What are they? In developed economies, debt is so high relative to GDP that a one or two percentage point increase would collapse the house of cards.
If we end up in a situation where inflation rises due to expectations and interest rates do not rise, what happens to the stock market? In my opinion, the key question is whether interest rates will rise if inflation does occur.
inflation + rising interest rates = default of states and zombie companies
inflation + 0% interest rates/negative real interest rates and the central bank as the sole buyer of the bond market = hyperinflation
Inflation + 0% interest rates/negative real interest rates + price controls + capital mobility restrictions + e.g. forcing the pension system to be a buyer in the bond market = ?
So, should we favor highly indebted or less indebted companies? In a scenario that relies on rising interest rates, they certainly won’t do well. In accelerating inflation where interest rates are not allowed to rise, they do best. What about industries? A company’s pricing power is certainly important, but such companies are already very expensive. What about companies/markets whose costs do not rise with inflation and which are not subject to potential price controls? Is there a sweet spot for this scenario? Producers of raw materials/agricultural and forestry land? Are there other industries?
Thank you, Thunder, that was an excellent reflection, which I’ve also considered but perhaps not as clearly categorized. A few comments on that:
I personally prefer debt-free companies because it’s much easier for companies to take on debt than to pay it back. Debt repayment becomes even more difficult if costs rise without the pricing power to pass those costs on to product prices.
I believe that inflation will come to developed markets indirectly through the growth of consumption demand in emerging markets, and possibly through climate policy. Many raw material prices have already risen over 100% from their COVID-19 lows and broken decades-old all-time high (ATH) prices. Copper has traditionally been the strongest indicator of these, and it even has the humorous nickname “Dr. Copper,” and it just broke its ATH price.
In the big picture, China is gradually shifting from a producer to a consumer. The population is getting richer and older, and a growing share of production inputs is directed to the domestic market, while raw material imports are increasing. This increases the potential for demand-side inflation globally, especially in consumer goods where supply is limited. In the future, the price of emission allowances and, naturally, the price of carbon-intensive products will also rise if climate change is to be tackled seriously.
Global technological deflation will certainly continue. Competition for jobs and customers is globalizing, especially in digital channels. This will erode the salaries of expensive office engineers as developing countries catch up in know-how and compete for the same customers. This could lead to an intensification of stagflation in countries with high costs and wage levels. Costs rise, but wages do not.
Many Eurozone countries, the United States, and Japan are highly indebted and are unlikely to pay off their debts. Of course, there’s no need to pay off debts as long as the currency is accepted in international markets, or as long as developing countries are willing to exchange their produced goods (mainly raw materials) for dollars and euros. This pattern has, of course, worked very well for us rich countries. We print money out of thin air, and developing countries do the dirty work, pollute their own environments, and also the atmosphere, and accept money printed with a press.
Central banks are unlikely to let states default, meaning money will be printed as much as needed for states. Depending on external factors, inflation and stagflation can be a nuisance in this process. Many indebted poor countries are already plagued by these external factors, and all money printing raises inflation. The United States and the dollar are the most immune to the constraints of money printing due to their high reserve currency status, but on the other hand, when the limits to money printing are reached, the dollar will also suffer the most and may eventually even lose its reserve currency status.
I don’t personally consider it entirely certain that inflation will ultimately accelerate, and it’s quite possible that inflation will subside again in the winter to its traditional path. However, I see clear upside in the market in many assets that perform well under high inflation and even stagflation. So, one could say that fire insurance is still in the discount bin, even if you can already smell the smoke.
Growth companies focusing on technology and ESG (Environmental, Social, and Governance) have enormous potential, and they will hopefully solve the problems that plague us. If successful, these companies will even solve climate change and continue a strong deflationary spiral. Deflation is only good for consumers when things can be bought cheaper, as long as deflation doesn’t hit one’s own salary or income.
Unfortunately, I count myself among value investors, and I don’t find these growth companies with P/E > 50 and P/S > 10 to be interesting investment targets in any way. From a value investor’s perspective, there is a clear bubble in these, and one simply cannot invest in them, even if they do good for the world. Growth companies suffer if inflation and interest rates rise, as future profits, far in the future, are discounted to the present at a higher interest rate. So, in growth companies, the downside risk is clear if inflation becomes a more permanent phenomenon.
The problem with quality companies, on the other hand, is that they are subject to strong financial leverage from investors. Investment targets of high quality (liquid, low volatility, rising price trend) receive more leverage from the market than less quality companies. Perhaps most clearly, this effect of leverage on quality is evident in the housing sector, but the same phenomenon also applies to the stock market. There is no problem with financial leverage as long as interest rates remain low. If inflation rises, then the risk of rising interest rates also increases, and then financial leverage starts to work in the opposite direction. Those who invested with debt sell their assets, bringing down the market price of quality.
At the systemic level, I have narrowed down my inflation/stagflation-safe targets:
Thunder’s points about forests probably fit this very well, and I hadn’t previously considered that market. I don’t know the forest market very well, but this gave me an “aha!” moment to study it! Thank you!
Thanks for the great answer and insights. Reciprocity and gaining something from others’ thoughts is probably at the core of any discussion forum.
It is generally thought that following macro data and the inflation/deflation/stagflation discussion is a waste of time for investors because it is so difficult to predict. Predicting is difficult, but in my opinion, there are benefits to following it. By preparing for different scenarios, one can better focus their own monitoring on individual markets, industries, and companies. Fairly efficient markets mostly price future events correctly, so by studying the price trends of these monitored industries, one can find good companies/industries/markets that have a nice macroeconomic tailwind or, more trendily, a megatrend. I think that precisely detecting these new megatrends early can be the key to outperformance in the future. The current megatrends, already known to everyone, are already priced into the markets, and it is difficult to beat indices with them.
The assessment of the effects of debt leverage was a good perspective. It is true that debt leverage acts as an amplifier for both increases and decreases. Highly leveraged targets then correct very sharply. A good example of this was the approximately 30% price change in the entire cryptocurrency market on Wednesday. I personally think about indebtedness more within a company. If a company has a lot of debt and we end up in inflation/stagflation where interest rates are not allowed to rise, the company’s debt melts away as if by itself, and then its enterprise value rises rapidly. If this could be combined with pricing power and the company’s own costs rising less than the general price level, then tailwinds would come from three different factors. If we end up even approximately in the scenario I outlined last (Inflation + 0% interest rates/negative real interest rates + price controls + capital mobility restrictions + e.g., forcing the pension system to be a buyer of the bond market = ?), then the bond market will certainly become the most important factor. If pension institutions (as is already partly the case in Europe) are legally forced to become owners of emerging market bond markets that increasingly offer negative real returns, then they will have to sell other assets. This, of course, leads to a failure of pension promises, but that is likely the outcome in almost all possible different scenarios, and it is a different discussion. However, these institutional sales would particularly affect the stock markets of developed economies. Should we also exclude the assets/markets they own in this scenario? What would be left then?
"At the system level, I have narrowed down my inflation/stagflation safe targets:
→ all these are good points. Does the emerging market value meet all these points? That is, exaggeratedly, for example, a suitably indebted emerging market country/forestry company or a raw material producer with clearly positive cash flow. The most interesting markets for this could be, for example, Russia, Turkey, and Egypt. The valuations of these markets are appropriate, everyone hates them, and their demographic development is also favorable. Unfortunately, there is always a flip side to the coin, and in these, it is, of course, political instability.
However, markets do not develop linearly, and there are bumps both uphill and downhill. Especially in crashes, all assets correlate with each other, and if some kind of shock/crash is seen in developed economies, these will also be affected. Some kind of trailing stop-loss strategy is probably also appropriate when investing in these…
Emerging Markets:
I’ve had a fairly large position in Emerging Markets, and so far, it’s been the wrong choice in terms of returns. On the other hand, I bought these for a long-term portfolio, and the fundamentals haven’t changed, so there’s been no reason to reduce their weight. Valuation levels have indeed dropped, but that doesn’t bother me as I’ve been ready to buy.
Now, in the very last few weeks, my portfolio has also gone up, even though there seems to have been a broader decline elsewhere. This usually indicates that the portfolio contains suppressed and unpopular assets, and some kind of bottom has been reached. However, I certainly don’t rule out the risk of going down even further.
In emerging markets, returns have long been reduced particularly by the decline in local currency values. Stock prices might have tripled in local currency, but in euros, their prices might have fallen by -50%. This is the biggest materialized risk associated with emerging markets for me. This trend doesn’t seem to have completely ended yet, although the exchange rates of the ruble and yuan appear to have made at least a temporary turnaround. In any case, I would avoid markets where the currency value is in a trending decline. In these cases, low valuation multiples are low for a reason.
In ETFs, the share of financial services is often also large. I wouldn’t want these financial sector companies in my portfolio, even though they apparently benefit from inflation or at least higher interest rates. The counterparty risk of ETFs also concerns me, and I don’t see following them as a very constructive activity. For these reasons, I have tried to look for direct stock purchases.
Telenor and Telecommunications:
One of my monitored targets is Telenor from the Norwegian stock exchange, which generates a significant portion of its revenue from Central and Southeast Asia. Telenor also has longer-term growth potential in IoT and 5G. From a value investor’s perspective, the numbers for the telecommunications sector also look good, if not very good. The only problem is the high indebtedness of the telecommunications sector. Telenor, on the other hand, has the Norwegian state as its main owner, so it certainly won’t run out of money, and with a positive cash flow, debts can be paid off in a relatively short time frame if dividend distribution is abandoned for a few years. Telenor is relatively more expensive than other companies.
The telecommunications sector also has many other attractive targets, and many have exposure to emerging markets. However, I’m not entirely sure if the long-lasting low pressure is over yet. These may also be susceptible to rising inflation, especially with 5G investments ahead.
Gazprom:
In the spring, I bought into Gazprom. There is more than enough political risk here. For the previous year and possibly this year, earnings have been under a lot of pressure as gas prices were very low.
On the other hand, large investments of tens of billions of euros are nearing completion in the coming years, which will significantly increase revenue. Gas prices also appear to be normalizing to a higher level in Europe. Gazprom has also invested in growing Central Asian and Chinese gas markets, which creates growth far into the future. Gazprom is also set to become the world’s largest helium producer within a few years.
A risk for Gazprom is that the globalizing LNG market might erode its European market share, but on the other hand, the development of LNG infrastructure and the “commodification” of natural gas will increase global gas demand, which is unlikely to harm the owner of the world’s largest gas reserves in the long run.
Natural gas is discriminated against as a fossil fuel, but I personally don’t believe we will get rid of it entirely in the next 30 years. It may even be the opposite. As coal is phased out, it is currently being replaced by wind power, solar power, heat pumps, and natural gas. This appears to be leading to an increase in natural gas consumption even in countries strongly opposed to fossil fuels. Natural gas also replaces oil use, for example, in maritime transport. Thus, the “stranded assets” risk in natural gas is, in my opinion, rather small, at least in the next 30-year perspective, although its growth potential in Europe is limited. Gazprom may also have growth in the “blue hydrogen” market, but this will only be relevant for revenue and cash flow in the future.
If inflation and interest rates start to rise, and metal prices continue to increase, this will particularly erode the relative competitiveness of renewables. Renewable energy sources are often capital-intensive and require a lot of metals. I believe that the rise in metal prices has partly been based on this speculation about the growing metal needs of renewables. However, renewables will be pushed into the market by various means around the world, so growth in renewables will certainly not stop, but the real cash flow for investors could be very small if interest rates and metal prices rise.
Also, natural gas fracking operations in the United States could be under pressure as money and metal prices rise and US climate policy tightens. This would improve Gazprom’s relative position in the gas market.
Fortum-Uniper:
Fortum-Uniper is another stock that offers strong exposure to natural gas and partly to Russia, but here the valuation multiples are considerably higher than in Gazprom, and I’m not entirely sure if the political risk is any smaller in the EU’s energy market than in Russia’s. Fortum certainly has a lot of hydropower, which will still be grinding out energy in 2100, but that’s beyond my investment horizon. Hydropower also has a clear windfall risk if hydropower produces “too” well for its owners while voters pay expensive electricity bills. In any case, I regret not buying Fortum during the corona dip.
Buy Button:
Telenor and Gazprom are currently under the “buy button” and close monitoring, but I was hoping for a May buying dip for these, which hasn’t really materialized. Now I’m waiting for the early-year results to see if my radar is at all accurate for these before I start accumulating.
I’ve accumulated a good amount of cash in my portfolio, so broader market turbulence with dips would be welcome, but the budding acceleration of inflation appears to be the biggest risk in holding that cash pile. The power of inflation has already been seen once with EM ETFs… “Cash is trash,” some say.
That’s true about Telenor’s situation. I think Telenor is affordable at its current level. It’s a reliable and stable operation. I also think the NOK currency strengthens that.
There hasn’t been much discussion here about inflation and rising interest rates, even though they are now a big part of the global picture after a long time.
So, I’d like to spark a discussion about potential winner and loser stocks in an environment of high inflation? With my limited experience and knowledge, I would venture to put Sampo in the “winners” category.
Another question/wondering: My bank once suggested various funds to me specifically because “money shouldn’t just be sitting in an account, even if its value decreases.” And now that the value of money is genuinely starting to decrease, stock prices, in general, are specifically falling/have already fallen slightly. So what am I not understanding?
Even if share prices drop, stocks are a reasonably good hedge against inflation in the long term. Rapid inflation may erode a company’s profits on a quarterly or annual basis, but for a cup factory, for example, rising raw material costs can eventually be embedded in product prices, so that increased raw material costs are recouped from the consumer’s pocket.
Five rate hikes are predicted for the US this year:
“Goldman Sachs expecting five rate hikes this year”
https://www.investing.com/news/economy/goldman-sachs-expecting-five-rate-hikes-this-year-2752514
Here’s an update. Inflation has indeed run high, just as I suspected. I took out a 10-year fixed-rate mortgage at the right time.
I also understood the importance of investing in raw materials, but the Russia risk hit those investments hard. I’m a bit annoyed that some of the assets I was monitoring have risen hundreds of percent, while my Russian investments have effectively dropped 100% and I can’t even get rid of them. Well, luckily these are small enough stakes that the world won’t end. But we learn from this and from kleptocracy.
I should have considered geopolitics a bit more. Russia is categorically blacklisted for the rest of my life unless a more liberal government takes its place there.
When interest rates fall, it’s probably smart to take out a new loan at a lower rate and pay off the old, higher-rate loan early. But what methods do companies have to control interest expenses on variable-rate loans specifically in an environment of rising interest rates? Some derivatives? How effective do such methods tend to be? For example, if interest rates double, do interest expenses only increase by half?
From time to time, interesting news comes from the industry. I used to be the CEO of a large Finnish industrial company, and I’ve kept good colleagues from that company. The latest “rumors” I heard were that a large Central European hardware supplier has raised its prices several times in the last 6 months, and now the next increases are 30% in May and another 30% in July. With what kind of capabilities are such increases passed on to the end-user?
And off we go again. I don’t believe that the transfer of costs to prices can continue at this rate for very long. As a bear, I only see dark clouds for the construction industry and across Finland as a whole. Is a recession ahead? Will we see industry bankruptcies if this development continues? As a kitchen economist, I suspect that Finns’ purchasing power simply cannot withstand this price increase in the long run, which will shift consumption to acquiring essential products and filling the piggy bank. Real economists could comment on this if they have time from their May Day rush 
The shortage of construction materials is reflected in the ordinary consumer’s wallet. For example, rising material costs in renovation projects are directly passed on to customers in bids.
– We have to pass the material cost on to the customer’s price. There is no other option, Männistö says.
Construction entrepreneur Antero Ahtiainen says the same.
– You just have to add a zero to the bill and negotiate with the owners if they still want to complete the project. There are no alternatives because the contractor cannot pay for it themselves, Ahtiainen says.
Do they agree to pay more?
– Some hesitate. Others say that the project will be done, no matter the cost. But households, in particular, are in trouble, Ahtiainen states.
Here we are, past the magical zero threshold, meaning the first full week where the 12-month Euribor is steadily in positive territory – and that, of course, means a negative sign for mortgage and other debtors. Those with more foresight may have implemented homemade (cost-free) interest rate hedging, which has been suggested in the press. Some have set up hedges by buying a solution from a bank. It remains to be seen whether the rising interest rate trend is stable, bouncing up and down, or even accelerating?
I’m not sure if this is the right thread for my question, but I couldn’t quickly think of a more suitable one.
As a result of the US interest rate hike, I might be interested in diversifying a portion of my portfolio into US high-credit-rated fixed-income securities. Inflation would certainly hit hard, but less so than holding cash.
What would be the most cost-effective and sensible way to make these investments?
Perhaps diversifying into several companies, with amounts ranging from a few thousand to tens of thousands per interesting security. An ETF or similar might also be of interest. Accounts are with Mandatum and Nordnet.
