Morningstar - Q3 2021 - 22

Dispatches
Stock Returns Usually Beat Inflation Rate
CPI Inflation
S&P 500
10-Yr Annualized
30%
20
13.91
1.68
12/31/56
12/31/76
Source: Morningstar Direct, U.S. Bureau of Labor Statistics. Data as of 03/31/2021.
12/31/96
03/31/21
10
-10
VVPLX, buying companies that can pass
on or benefit from price increases is a permanent
feature of their process, as top holding
Mastercard MA illustrates.
Bill Nygren's inflation wariness has led him
and the other managers of Gold- and Silver-rated
Oakmark OAKMX and Oakmark Select OAKLX
to increase their discount rate for companies
by 2 percentage points relative to what
the bond market currently implies. For context,
$100 five years in the future discounted
10% annually would be worth $62.09 at present.
That value would drop to $56.74 with a 12%
discount rate.
While that spike may prove transitory, inflation
now has a longer leash. Since August 2020, the
Fed has said it will tolerate heightened inflation for
short periods and try to bring it back down to
2%, on average.
The market has become increasingly worried,
according to the break-even rate for 10year
Treasuries and Treasury Inflation-Protected
Securities. Since the Fed's policy shift, the
gap between their yields-a proxy for investors'
inflation expectations over the next decade-
climbed from about 1.7% to more than
2.5% recently. Such an increase in inflation can
have a significant effect. At 1.7% annualized
inflation for 10 years, the purchasing power
of $100 today drops to $84.49 then. If
inflation turns out to be 2.5%, that purchasing
power erodes to $78.12.
Stocks have consistently increased long-term
investors' purchasing power, thanks to
businesses' ability to raise prices and create
new sources of value. Over rolling 10-year
periods measured quarterly, the S&P 500's return
has beaten the CPI in every era dating to
the 1950s except for when high inflation reigned
from the mid-1970s to the early 1980s and
during the depths and aftermath of the 2008
global financial crisis.
Its impressive record notwithstanding, the
stock market could again struggle to outpace
22
Morningstar Q3 2021
inflation for an extended period. Not every
manager thinks so, however. Guy Lakonishok, a
quant manager on LSV Value Equity LSVEX,
which has a Morningstar Analyst Rating
of Silver, says inflation is likely to be marginal and,
if anything, help this deep-value strategy.
Inflationary fears often hurt growth companies'
valuations more by reducing the current
value of their future earnings, which make up
a greater share of their intrinsic worth.
Growth managers Kathleen McCarragher and
Blair Boyer of Gold-rated Harbor Capital
Appreciation HACAX aren't worried. They think
recent supply constraints will prove temporary and
inflation will settle near the Fed's 2% target as
economies sustainably reopen.
Some managers express their inflationary concern
in subtle ways. The managers of Gold-rated
American Funds American Mutual AMRMX let
its cash stake dip to 3.9% in March from its
historical double-digit weighting. With cash
yielding little to nothing and inflationary pressures
mounting, they're staying more fully invested
than in the past.
Tom Huber is tilting Silver-rated T. Rowe Price
Dividend Growth's PRDGX portfolio toward
companies with pricing power, especially
within industrials, real estate, and consumer
staples. For C.T. Fitzpatrick and McGavock
Dunbar of Neutral-rated Vulcan Value Partners
Michael Kass of Bronze-rated Baron Emerging
Markets BEXIX thinks developing-markets
stocks will benefit from a weakening U.S. dollar.
In his view, an inflationary upside surprise
is likely enough that he has taken profits from
secular growth stocks that have run up and moved
those profits into more-cyclical companies.
Among the managers we surveyed, inflation is
of greatest concern to Matt McLennan and
his comanagers on Silver-rated First Eagle Global
SGIIX and First Eagle Overseas SGOIX as
well as Neutral-rated First Eagle U.S. Value FEVIX.
McLennan and team worry that technological
advances, globalization, and central bank
policies won't be able to tame inflation to the
extent most assume. Thus, each strategy's
most recent portfolio has a roughly 10% gold
weighting as a hedge against calamity, including
a surge of inflation. They are also focused
on firms with strong market positions, often
backed by real assets such as timberlands.
Whatever happens with inflation over the
coming decades, investors should pay
greater heed to their portfolio's real rather than
nominal return. It is only the former that
will matter in the end.
Alec Lucas, Ph.D., is a manager research strategist at
Morningstar Research Services LLC.
Morningstar - Q3 2021

Table of Contents for the Digital Edition of Morningstar - Q3 2021
