The Rise of Inflation

The Consumer Price Index (CPI) hit a 39 year high with inflation hitting 6.8% year-over-year as of the end of November. Therefore, it is not surprising that inflation is one of the most searched terms among Fortune 500 employees and the general public. It is so widely searched that the search for “inflation” on media research site Factiva shows more hits in October than during any month in the past decade.

So what is Inflation? By definition, Inflation generally is caused by too much money chasing too few goods.

The increase of money is due to government policies to counteract the COVID-19 depression. They spent trillions boosting the economy and paying people not to go to work. Consumer savings were also helped by the freeze on student loan payments, mortgage payments and the eviction moratorium. The pent up demand from pandemic lock-downs is now flooding the economy.

The lack of goods is a result of labor shortages, global supply chain constraints and an increase in freight and shipping delays

These have impacted inflation as has been shown by common inflation indicators.The most common indicator is the CPI. The CPI essentially measures the change in prices paid by urban customers for the same basket of goods over time. The CPI’s current 39 year high delineates from the Federal Reserve’s standard 2%, thus showing that we are in a time of rising inflation.

However, even though Inflation is present, the CPI is not representing all of the impacts of inflation just yet. The CPI is broken down into different weightings where measuring price changes is relatively simple, except for the price changes for the category of Shelter.

The Bureau of Labor Statistics (BLS) has a category in the CPI called Shelter, which accounts for 30% of CPI. This category is broken down into two sub categories: Owners’ Equivalent Rent (OER) at 23% of the CPI and the second category Rent of Primary Residency at 7% of the CPI.

Unbeknownst to most people, the BLS only uses rent and rent proxies to calculate CPI. This is because the BLS believes the prices of houses and other residential structures are financial assets, not consumption items.

To calculate OER, the BLS uses the following survey question: “If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?”

Do you know what your home is worth? Do you know how much you can rent it for? Most homeowners have a much better idea of what their house is worth than how much they can rent it for.

Given 23% of CPI is based on a guesstimate of homeowners, is it reliable to use OER to estimate rental prices?



The BMI doesn’t account for home prices, however home prices are a vital component to rent. This is because a more reliable estimate of rental price would be to account for home prices as that would affect mortgage rates. In turn, that would affect rent as most owners want to make a profit as they want to make more than the maintenance, taxes and mortgage payments.

A good indicator of home price is the Case Shiller Home Price Index.

Since 2001, the Case Shiller Home Price Index has been volatile. At the same time, OER has been incredibly stable. From a statistical perspective, Case Shiller is over eight times more volatile than OER. Furthermore, the two data sets have a near-zero correlation with each other.

The following graph shows imputed mortgage payments based on historical mortgage rates and the Case Shiller price index. Imputed mortgage payments should serve as a strong proxy for rental prices despite not including homeowner maintenance and taxes.



Imputed mortgage payments are more volatile than Case Shiller due to constantly changing mortgage rates. However, the critical point is that this simple measure of home rental costs strongly compares with home prices.

Given OER does not correlate with home prices or imputed rental prices, we have zero ability to forecast 23% of CPI accurately. As such, we have no idea if soaring home prices will affect CPI. Rental prices, contributing 7% to the CPI Index, should be much easier to forecast. The rent survey question is not hypothetical like OER. They directly ask renters how much they pay in rent. In theory, this should provide a good measure of rental prices. Unfortunately, theory and reality are not always the same. Zillow puts out a rent index called the Zillow Rent Index (ZRI). Their index uses actual rental prices and Zestimates, or estimates of rental prices on properties not for rent. The graph below compares the BLS Rent index with Zillow’s ZRI.
Zillow’s Observed Rent Index, rose by 9.2% year over year in September.



Meanwhile, the U.S. Bureau of Labor Statistics calculated that “rent of primary residence” rose "only" 2.4% year over year in September while “owners’ equivalent rent of residences” rose by 2.9%. If one were to accept Zillow’s Observed Rent Index data as a reasonably accurate depiction of the pace of rental rate increases—and it is similar to in keeping with several other independent sources of national home rental data—the incorporation of that data into the CPI weighting system in September would have caused CPI to be measured at something like 7.3% rather than 5.4%. 


The Federal Reserve would like to shoot for a 2% inflation rate and per their own definition, prices are clearly not stable. Prices are causing consumers and households to worry. Housing affordability indices have deteriorated meaningfully in the United States, and in other countries for that matter, as a direct result of materially negative real interest rates driving home price increases.



Auto prices have spiked as a result of supply shortages and prices/valuations of many financial assets are at levels rarely seen. In defense of our Federal Reserve they feel this is temporary or what they call transitory. However, we cannot identify if this is “temporary” inflation. I am not sure the semantics matter much when year over year home price gains are running in the high teens. For example, an 18% year-over-year “transitory” house price increase is the equivalent of 5.7% persistent price gains for three consecutive years, except that the increase all in one year is likely to be more economically destabilizing. While the companies in our portfolios are mostly reporting higher wage and input costs, they are also noting an ability to raise prices and potential profitability.

In the world of inflation caps and floors, this translates into a probability of inflation exceeding a certain threshold level over the lifetime of the cap. The good folks at the Minneapolis Fed map these inflation cap prices into an easier to understand probability (see Exhibit 3 below).



As of 6/30/2021 | Source: Federal Reserve Bank of Minneapolis

They don’t go as far out as 10 years, but at the 5-year horizon, the current market price suggests there is a 40% probability of inflation being greater than 3%. So in order to hedge with an inflation cap, you would need to believe that there is a higher than 40% chance of 3% per year inflation over the next 5 years.

The Fed is still very convinced inflation is “transitory”. They feel many of the factors responsible for the bulk of this year’s surge—including labor market shortages, post-vaccine spending surges and specific supply-side issues—are likely to be temporary. Does “temporary” mean 6 months or 2 years of high inflation?

The Atlanta Federal Reserve Bank’s GDPNow Forecast has pegged GDP at 8.6% growth for the fourth quarter of 2021. This is a large rebound from 2.1% in the third quarter. In October, economic data showed that incomes are continuing to rise. This is a potent fuel for persistent inflation, contrary to what the Fed has been saying.

A report from the Bureau of Economic Analysis showed that spending on durable goods rose by 3.3% and spending on services increased by 0.9%. Wages increased and have offset unemployment checks and the savings rate is still at a healthy level of 7.3%. These numbers suggest that Americans are still financially able to continue shopping.

The large growth in the economy and the increase in spending on durable goods and services means that demand is continuously growing. Americans have been continuing to buy appliances, furniture, new and used cars, and pricey homes. Horizon Investments says, “such strong spending despite the well-known supply chain delays and multiple sticker shocks is contributing to inflation remaining uncomfortably high for longer than many would have expected.”

Now the contrary point of view from some of the greatest minds in investing was sounding alarms earlier this year that the Fed is playing with fire by artificially suppressing interest rates and causing asset bubbles. Here we are six months later and despite what the Fed says, it is obvious to all Americans that inflation is real. Food prices, gasoline, insurance, car prices, home prices, rent, utilities and many more prices are skyrocketing. These price increases are actually accelerating with severe logjams at ports around the world. One reason for the much publicized glut of container vessels in the waters off the Port of Los Angeles is a shortage of truck drivers and warehouse space. There are currently four million more job openings than people to fill them in the US. The reasons for this are many, but it definitely adds fuel to the inflation fire.

We would also like to point out that the longer that inflation lingers, the more likely the expectation for higher inflation sets in, and it becomes self-fulfilling. We will continue to monitor the situation closely.

Regardless of whether we have more sustained inflation going forward, we do expect that interest rates will eventually rise from historically low levels. This makes intuitive sense based on history. Moreover, we recognize that central banks appear to be approaching policy shifts. Higher bond yields make owning fixed income securities relatively more attractive and have the opposite effect on equities. The higher interest rates climb, the lower the present value of a business’ future earnings, which tends to lower equity valuations or P/E (price-to-earnings) ratios. That said, we believe favorable earnings growth can overcome any adjustment to market level valuations.

Given these facts, how do we protect against these inflationary pressures in our investment portfolios?

Debunking the Myth of Commodities Being a Good Hedge Against Inflation

Recent surveys and common belief is that commodities are a good hedge against inflation.



But what does that empirical data show? Before we look at how commodities fare against inflation, we should first split commodities into two groups: oil and the other commodities.





Oil did extremely well in comparison. So we can see that commodities without oil are simply a consistent store of value.



If we compare commodities without oil to the CPI year over year, then we only establish a 0.3 correlation, meaning that the CPI is only somewhat followed by commodities, thus commodities are unable to hedge well against inflation.

Now we take a look at oil.



We can see that there is a 0.5 correlation between oil and the CPI. This is better than commodities, however it is still not as good as we would like.

From this data, we can see that commodities are really not that great of a hedge against inflation.

Why Value Investing Beats Inflation

As inflation rises generally so do interest rates. So the risk of inflation is higher interest rates

The Federal reserve opinion is that inflation is transitory and they seem to feel that inflation will settle to their 2% target. The Fed has recently communicated that they will stop buying bonds and mortgage-backed securities which is keeping 10 year treasuries and mortgage rates at artificially low levels. When the bond buying stops it seems logical that Treasury and corporate bond yields might drift up to levels at which investors could earn real (inflation-adjusted) returns.

When bond yields rise they would then offer a little stiffer competition to stocks than in recent years, and as a result, price-to-earnings (P/E) multiples might shrink. As rates rise the cost of borrowing rises which will also have an impact on stocks. The companies most affected are generally high tech companies who will be receiving most of the earnings many years in the future.

This change to “normal” capital markets and interest rates would represent a healthy change, even though it would create some headwinds and volatility for stock and bond prices.

Volatility, although uncomfortable, could be beneficial. A little market chaos and a temporary price shakeup for stocks could actually turn out to be positive for our long-term returns for our clients.

As we have discussed in many past articles, price and value do not always move together. So if a valuable company has a decrease in stock price it actually may be helpful to the companies we own.

To understand why, we look to Benjamin Graham who wrote one of the best books ever on Value Investing called, “Intelligent Investor”. One of the most important words ever written about investing is in chapter 8 of Ben Graham’s The Intelligent Investor. In that chapter, Graham introduces us to what he calls the parable of Mr. Market. The story is meant to help change the way that his readers deal with the fluctuations in the prices of their investments.

Graham asks the reader to imagine that they are a partner in a private business with this odd fellow called “Mr. Market”. Every morning without fail, Mr. Market comes into work, looks around a bit and then tells you what he thinks your share of the business is worth. He then goes on to offer to buy your share of the business or sell you his share of the business at that price. Most of the time the price he is proposing sounds reasonable given the fundamentals of your business, but sometimes Mr. Market would be on one of his occasional emotional rollercoasters and would propose a price that is completely out of whack with the business’s reality. Further adding to the peculiar nature of Mr. Market, he is never offended if you simply ignore him and do not bother to look up from your desk while you went about your work.

Graham tells us that on most days the rational thing for you to do is to simply ignore Mr. Market. On odd days when he offers you a silly cheap price compared to business reality it would be wise for you to try to buy him out if you’ve got some extra cash in the bank. On the other hand, if he quotes you a ridiculously high price and you’ve got other business opportunities to invest in then you should seriously consider selling your share of the business to him. Either way, there is absolutely no harm whatsoever in simply ignoring him.

That is how rational investors should think about their equity investments (stocks). On any given day, week or month, Mr. Market will be offering you prices to buy or sell. If the prices are very low relative to what the businesses value is, you should consider buying more and if they’re too high, perhaps you should sell and invest the money somewhere else. Most of the time you are much better off not even looking at the prices and focusing on the business performance of the companies whose shares you own.

Over long periods of time, the fundamental performance of the businesses that you own parts of will be the main driver of your investment performance. Stock price movements in the short term are nothing but noise.

We have always behaved this way at TRG and believe that it has given us a tremendous advantage. For one, it detaches our own emotions from the manic-depressive swings of the market. We believe this allows us to make better decisions that are rooted in fundamental analysis instead of emotions. It also means that we’re a lot less stressed out about how our portfolio is behaving in any month, quarter or year. Most importantly, it turns market volatility, which most investors view as a bad thing, into a good thing. Volatility becomes a source of potentially lucrative investment opportunities.

So let's look at some examples of companies that take advantage of Mr. Market and volatility. Some of our favorites may even be cheering for a bear market and price correction. Berkshire Hathaway, with over $150 billion in cash reserves, made some of its best investments during the 2008-2009 financial crisis. Berkshire “helped out” Bank of America(which it owns at $5 a share), Goldman Sachs, and others that needed liquidity…badly. Most of our companies would like to make acquisitions and/or buy back their own shares, and a weak stock market can provide golden opportunities.

We found value held up better and long-term corporate profitability remained steady in past periods of higher inflation. Investors’ focus should be on valuation.



Inflation, its effect on the market, and its implications for our portfolios have been frequent topics in recent client conversations. Whether caused by disrupted supply chains, shortages, government spending, or pent up demand from pandemic lock-downs, inflation metrics around the world have been ticking up, and it is impossible to know whether these inflationary forces will be transient or longer lasting.

As a firm we do not try to forecast the many moving parts of inflationary pressures from a macro perspective, but rather look at the impact of a multitude of issues, including inflation, on a company-by-company basis. However, to provide some context to the inflation discussion, we studied how value stocks performed during various inflationary environments, and the profitability of businesses in those same environments. In short, we found:

  • Commoditized businesses are affected more as higher input costs cannot be passed through to the consumer, if a commoditized business raises prices, then customers simply buy an identical good or service from a lower-priced competitor. The expected result is either lower sales, lower margins, or both. In contrast, differentiated products or value-added services are not as readily substitutable.
  • Advantaged businesses selling differentiated products or value- added services can often raise prices if needed and are more protected from inflation.
  • Value performed better during periods of higher inflation
  • Value remains the best alternative in equity and fixed income markets today that offers a double-digit earnings yield.


We reviewed a recent study on how expensive and cheap stocks performed during various periods of inflation over the past 60-plus years. One observed study is illustrated in Figure 1.

As you will see, cheap stocks have done well at higher levels of inflation, and, as periods of higher inflation often occur in conjunction with economic recoveries, this is consistent with our findings in past newsletters, that value outperforms in the five years following the start of a recession.

Figure 1: Cheap vs. Expensive Stock Performance Across Inflationary Environments



Source: Federal Reserve Bank of St. Louis, Sanford C. Bernstein & Co., Pzena analysis
Cheapest quintile price to book vs. most expensive quintile within ~1,000 largest US stock universe (equal-weighted data); returns do not represent any specific Pzena product or service. Chart calculated using monthly average of rolling 5-year annualized returns. Inflation bucket cutoffs are set such that each regime has the same number of observations. Low inflation cutoff is below 2.17% and high inflation is above 4.44%. Inflation is measured on a 5-year annualized basis rolling monthly. Data in US dollars 1960 – June 2021. Past performance is not indicative of future returns.

While on the surface cheap stocks seem to struggle in periods of low inflation, that conclusion lacks the nuance drawn out by looking at individual periods of low inflation. There were three unique, uninterrupted low inflation rate regimes: the mid-60’s, the period just prior to the global financial crisis and the period following the global financial crisis until today (See Figure 2).

Figure 2 – Three Low Inflation Periods



Source: Federal Reserve Bank of St. Louis, Sanford C. Bernstein & Co., Pzena analysis
1Cheapest quintile price to book vs. 2most expensive quintile within ~1,000 largest US stock universe (equal-weighted data); returns do not represent any specific Pzena product or service. Chart calculated using monthly average of rolling 5-year annualized returns. Inflation bucket cutoffs are set such that each regime has the same number of observations. Low inflation cutoff is below 2.17%. Inflation is measured on a 5-year annualized basis rolling monthly. Data in US dollars 1960 – June 2021. Past performance is not indicative of future returns.

All three periods showed solid returns for value stocks; however, the most recent period has been dreadful from a relative performance perspective versus expensive stocks. Because the duration and level of value underperformance has been greater this period than the prior two, value underperformed in low inflationary regimes overall.

Recency bias might lead one to believe that value no longer works in low inflationary environments. We believe, however, there could be a more nuanced reason. We suggest that what made the most recent low inflationary environment unique was an interest rate at period inception that was lower than at any point during the previous two cycles, and it dropped throughout the period by more than it had in any previous low inflationary period. The data suggests the extremely low and falling interest rates had a profound effect on the valuation of growth stocks.




While the two previous low inflation environments saw period ending price-to-earnings (PE) multiples of cheap and expensive stocks that were within roughly +/- 15 percent of the start of the period, the most recent period has been far different. The PE of expensive stocks has doubled since 2009, while value’s multiple is roughly unchanged. As pointed out above, we argue that the extremely low and falling interest rates led to lower discount rates, which mathematically have a stronger impact on expensive stocks than cheap stocks.

Following a four decade decline in interest rates, leaving them near record lows, investors should question what might happen to expensive stocks, which are near all-time highs, should interest rates start to rise. At this point cheap stocks are the only alternative in the equity and fixed income markets with a double-digit earnings yield (Figure 3).

Figure 3: Cheap Stocks Still Offer Double Digit Earnings Yield



Source: Federal Reserve Bank of St. Louis, Pzena analysis
Cheapest/Expensive earnings yield are based on the median stock within the cheapest and most expensive quintile based on price-to-normal earnings. The quintiles are measured on an equally weighted basis within the ~1,000 largest US stock universe. Price-to-normal earnings are Pzena’s estimates. Data as of June 30, 2021. Past performance is not indicative of future returns.


Turning to corporate profitability, we looked at the ROE of the market and found it was indistinguishable in low and moderate inflation environments, and roughly 150 basis points lower in high inflation environments (Figure 4). It is notable that we haven’t experienced a high inflation environment in 28 years, meaning the vast majority of the observed high inflation data points happened during an era in which corporate America was less efficient and more capital intensive than it is today.

Figure 4: Similar ROEs Across Inflationary Periods



Source: Federal Reserve Bank of St. Louis, Sanford C. Bernstein & Co., Pzena analysis
Return on equity is based on trailing 12 months and calculated using a simple average within each inflation regime; universe is the largest ~500 US stocks. Inflation bucket cutoffs are set such that each regime has the same number of observations. Low inflation cutoff is below 2.17% and high regime is above 4.44%. Inflation is measured on a 5-year annualized basis rolling monthly. Data in US dollars 1960 – June 2021. Past performance is not indicative of future returns.


This value cycle has been driven by extreme value dispersion between cheap and expensive stocks that was a decade in the making and catalyzed by the attractive earnings growth profile of cheap stocks over the next several quarters. Value doesn’t need inflation to work, but, should inflation pressures persist, historically a higher inflationary regime appears to be a tailwind.


  • Zillow Home Value Index (ZHVI): A smoothed, seasonally adjusted measure of the typical home value and market changes across a given region and housing type. It reflects the typical value for homes in the 35th to 65th percentile range.
  • Cash Shiller Home Price: The S&P CoreLogic Case-Shiller U.S. National Home Price Index is a composite of single-family home price indices for the nine U.S. Census divisions and is calculated monthly.
  • CPI – Consumer Price Index: The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. Indexes are available for the U.S. and various geographic areas. Average price data for select utility, automotive fuel, and food items are also available.



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Tags: Inflation, Hedge, Value