Preparation for rapid change in macroeconomic conditions is an intrinsic part of investing. Every investor must always stay reasonably prepared for big macroeconomic changes.
When we talk about big change, inflation is clearly a macro factor which affects equity investing far more than other indicators. When inflation falls continuously and remains on a downward trajectory, equity investing benefits immensely from that trend. Valuations tend to expand as markets start factoring in lower inflation into their future expectations of corporate profit. But when inflation begins to rise, we don’t see the trend reversing anytime too soon.
Inflation hurts the valuations of companies. Equity valuations contract more only whenever inflation rises, prolongs, and sustains. From experience, the actions of the central banks will eventually help countries tame inflation. But the time lag between recognizing inflation and taming inflation has never been to the market’s liking. When inflation rears its ugly head, investors need to immediately factor in a long-drawn battle to tame it.
Now, it is amply clear that the world’s battle against inflation is going to be a prolonged one. We will need interest rate hikes, reduction of liquidity, improving supply of important commodities, removal of logistic hurdles, ending wars and providing visibility of better times. All this is going to take a lot of heavy lifting and effort by central banks, governments, and corporations.
Corporate profits will change trajectories and the market needs to factor it in. At the moment markets are still factoring in a speedy return to lower inflation. It has not factored in a sustained battle against inflation. The market will need to reprice businesses, adjust profit estimates, and create a new valuation paradigm for inflationary times. As the market does this, the most overvalued businesses tend to get affected immediately and the trend spreads gradually to impact all businesses.
Investors with the patience, holding capacity, willingness to scale up and faith in good businesses can build a future-proof portfolio in better-managed companies at attractive valuations.