Peak inflation and value stocks

by Fidelity Viewpoints

Here are 3 reasons why inflation may soon slow—and value stocks could shine.

Key takeaways

• The recent surge in inflation may moderate in coming months.
• Higher bond yields, a stronger dollar and rising inventories may help slow inflation.
• Inflation may level off below current levels but slightly above the historical average.
• In that scenario, value stocks could shine.

The numbers confirm what you know if you've bought almost anything lately: Inflation is here. Driven by surging demand from consumers and businesses for goods and services, the consumer price index has risen 6.8% over the last 12 months while producer prices have jumped 9.6%. These are the highest readings in almost 40 years and reflect supply chain and production constraints as well as the strength of the recovery from the uniquely short and deep COVID-19-related recession.

When inflation began to surge last year, it was often mentioned along with the hopeful-sounding word "transitory." Now that phrase is passe and many wonder whether the US has entered another period like the 1970s where high inflation persists for years.

Not to worry, says Director of Quantitative Market Strategy Denise Chisholm, who studies market history. "My analysis shows that the runaway inflation of the 1970s was an exception, not the rule," she says. "High inflation historically tends to be self-limiting because it creates dynamics that can slow future inflation." Instead, she thinks inflation is likely to slow over upcoming months, leveling out closer to 3% and presenting opportunities for investors, particularly in value stocks.

Chisholm points to 3 things that are happening now that have the potential to help slow the pace of price increases over the coming months.

1. Rising long-term bond yields

One sign that suggests that inflation may slow is the recent rise in long-term bond yields. The yield on the 10-year Treasury note rose about 70 basis points during the 12 months through November, a jump on par with some of the biggest year-over-year increases of the past two decades. Increases in long bond yields push up rates on mortgages and other loans, which can curtail spending and take some of the air out of inflation.

2. A stronger dollar

The strong demand for goods that has driven up inflation in the US also has contributed to economic growth and interest rates that are higher than in other developed countries. The US dollar has leaped against other currencies as a result. The dollar could keep appreciating because US economic growth is likely to remain stronger than that of other developed markets and interest rates are expected to rise. Since 1999, when the dollar has switched from depreciating to appreciating, inflation during the next 12 months has slowed 70% of the time. A stronger dollar would further reduce the cost of imported goods, which could help offset other inflationary pressures.

3. Increasing inventories

Inventories have climbed despite snarled supply chains. Companies typically try to capitalize on strong demand and inflation by adding to their inventories so they’ll have more products to sell at high prices. As inventories increase, they eventually catch up with demand which helps to moderate inflation. The past year has been no different, despite the supply-chain bottlenecks that have gotten so much attention. According to the Institute for Supply Management (ISM) Manufacturing Inventories Index, inventories recently expanded as quickly as they have at any time in at least 20 years.

What it may mean for stocks

Chisholm believes that inflation is likely to level off at a rate that is lower than recent highs but still above 3%. That partly reflects the fact that the earnings of many companies increased significantly in 2021 and inflation tends to be closely related to the previous year’s profit growth.

While stocks overall have historically fared well when inflation was as high as 5% and have provided investors with hedges against inflation, some categories of stocks have performed better than others depending on how sharply the CPI was rising or falling. Says Chisholm, "Which stocks lead the market may depend on whether inflation falls to a relatively high or low rate. The answer has important investment implications."

Seeking value

Historically, when inflation has slowed but remained higher than average, value stocks—those that trade at lower prices than stocks of other companies with similar earnings—have been among the best performers. But while value may be poised to outperform the broader market, discovering value can present challenges, even for experienced investors. Joel Tillinghast, manager of Fidelity^® Low-Priced Stock Fund, points to Amazon as an example of how important sophisticated research is for value investors.

"The challenge of finding undervalued stocks is that accountants don't know how to value intangibles such as brands, intellectual property, and good will with customers," he says. Tillinghast says he, like many others, didn't spot the opportunity to invest in Amazon before it emerged as a retail juggernaut and exemplary growth stock. "For many years, Amazon reported either losses or not very big profits. At the same time, it was building up an increasing number of loyal customers who kept purchasing more and more stuff from it. Those customer relationships turned out to be very valuable, even though they weren't visible on the company's income statement."

Tillinghast says experienced professional investment managers can look for growing sales to identify companies with value that the market doesn't perceive. "We look for growing free cash flow, which is cash from sales that's greater than the amount of capital that they're spending on operations," he says. "Amazon's free cash flows were better than you would have expected given their not-very­ good profitability 10 years ago. That was a hint that their businesses were not very capital intensive. They were growing sales fast and they were producing cash that they could return to shareholders or invest in new businesses. Now their profits have been great."

Finding ideas

Value stocks now make up just 18% of the total value of US stocks, which means the large-blend or large-cap core mutual funds that are basic building blocks of many portfolios may be much more heavily weighted toward growth than they once were. “Over the last few years, growth stocks have outperformed value stocks,” says Naveen Malwal, institutional portfolio manager with Fidelity's Strategic Advisers LLC. “So some investors may be tempted to keep more exposure to growth stocks. But diversification across different types of stocks is a critical component of risk management. Our investment team believes that having exposure to both growth and value stocks may lead to smoother investment performance over the long-run.”

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