Inflation Asset Strategy: Areas to avoid

Michael Rudd, CFA | President, CEO and Portfolio Manager

This week, we received some important data from the US government that we thought we would point out:  The Core Personal Consumption Expenditures Index (PCE), which tracks the overall price changes for goods and services purchased by consumers. It is the preferred measure of inflation used by the US Federal Open Market Committee (FOMC) to set administered interest rates, which form the basis of the US Feds management of economic support and ultimately form a major input into inflation expectations. The FOMC has previously issued a hard target of 2.0% for PCE but more recently has changed that to an “Average Target: of 2%”, which would allow inflation to “run hot” to balance out the long periods of disinflation that we have experienced since the Great Financial Recession of 2008. Figure 1 presents that while the PCE level has dropped since the 90’s and mostly stayed below 2%, it appears to be rising recently. Where it goes from here is the crux of the debate. If it goes uncontrollably higher, then there are certain types of companies that might be at risk as their industry or business structure will make it harder for them to maintain stable margins.

  • In general, we would like to avoid companies that have “bond-like” characteristics, which means that they have limited ability to adjust prices higher to protect their profit margins in a rising price environment.
  • For example, large electric utility companies in Canada are regulated by the government and are able to charge a rate to clients that allows them to earn a regulated return on their assets. The rate is set by the government in consultation with the companies and consumer stakeholders. This means that there is a lag between an increase (or decrease) in allowable return as interest rates change. Unfortunately, the drop in regulated return seems to be quicker in a decreasing rate environment than the increase is in a rising rate environment. As the companies are not allowed to pass on price increases to customers as inflation rises, the cash flow for the owners of the assets (the shareholders) is compressed resulting in poor operating performance.
  • Another example would be a pipeline company where, again, the government sets a rate for transportation of liquids or gas and the company has to apply to a regulator to increase the rate as costs increase. This application process can result in a limited ability to adjust in a fast-moving environment, which could impair cash flow.

“This means that” as inflation expectations change, we have options as investors to identify companies that provide real protection. We should also be mindful to allocate capital away from those organizations that are at a disadvantage. Fundamental company specific analysis will provide opportunities and help us avoid problems.

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