Portfolio Manager Brian Demain explains how expectations for faster economic growth and higher levels of inflation could lead to a market dynamic that equity investors have not seen for the past decade.

Key Takeaways

• As expectations for economic growth and inflation rise, companies may experience different sources of margin pressure, as well as a new valuation paradigm in capital markets.
• Policy makers may also be less willing to backstop market pullbacks, potentially ending the exceptional levels of capital appreciation experienced by equities in recent years.
• In light of these market dynamics – one where a rising tide may not lift all boats – we believe investors need to be discerning, focusing on companies with strong competitive positions, capable management teams and proven profit models.

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Brian Demain: While the market has in the most recent weeks become a little less concerned about the forward predicted levels of inflation, it’s important to be mindful that if you look at TIPS [Treasury Inflation-Protected Securities]-implied inflation breakevens, that they are materially higher for the next five years than what we’ve seen over the – what’s been realized inflation over the prior five or 10 years. And this just creates a different market backdrop than the one most of us have invested in over the last decade. We should see higher levels of nominal growth coming out of basically all of our companies. We should see different sources of margin pressure than we have over the past decade. And we may see a different valuation paradigm applied to companies in this type of higher, nominal growth environment.

One thing investors need to be mindful of is that there is a – we’ve had exceptional levels of capital appreciation in the equity markets over the last not just three years but the last 10 years, and investors have been conditioned to not expect extended drawdowns due to the backstop of the Federal Reserve. If the real economy is in a decent place, we can probably, it’s possible that the Federal Reserve will be less inclined to backstop capital markets if they get tripped up a little bit. And with that type of risk present, that is something that many investors also haven’t sort of lived through given the last 10 years of market history. So, it would be an overstatement to call it a sea change, with expected inflation going from the mid-ones [1%] to the mid-two [2%]. But it is a meaningful change in the investment landscape that equity investors should be mindful of.

In this type of market environment, it’s important to focus on selecting investments that will benefit from this change in dynamic, companies that are well positioned and delivering strong growth but also have proven profit models, strong competitive positions and strong management teams. It could be a more discerning market going forward than it has been over the last few years.

In a market environment where it’s no longer a situation of rising tides lifting all boats, it’s important to be very discerning of company fundamentals. We may see a greater dispersion of performance among stocks in the market than we have over the trailing years.

 

TIPS = Treasury Inflation-Protected Securities

The 5-year TIPS/Treasury breakeven rate reflects the average inflation rate that market participants expect for the next five years and is based on the difference between the 5-year Treasury rate and the 5-year TIPS rate.