Even schoolchildren learn about the hyperinflation of 1920s Germany.
By late 1923 the German mark was losing value so quickly that its workers were paid twice a day.
People pushed wheelbarrows full of near-worthless banknotes to the grocery store. Others reverted to the barter system. A baker might swap a loaf of bread for a few turnips rather than accept paper money that would soon be good only for kindling.
Of course what makes Germany’s hyperinflationary warning especially potent is it helped set the stage for the rise of history’s most murderous failed artist.
But periods of relentlessly soaring prices are not so unusual.
Did you ever hear about the inflationary explosion in early 1990s Yugoslavia?
Between 1988 and 1994, inflation in the now-defunct country ran so high its central bankers were adding zeroes to bank notes with every new issue.
With prices doubling every few days – every 34 hours at the peak – that was a lot of zeroes.
Rumour had it the bank began to slap images of random children on its notes instead of the usual scientists and philosophers because the paper wouldn’t be in circulation for long anyway.
The country’s financial mandarins eventually released a 500 billion dinar banknote.
Stand aside Bobby Axelrod! In 1990s Yugoslavia anyone could be an unhappy billionaire.
Up, up, and away
For a long time these bouts of hyperinflation seemed more like fairy stories than cautionary tales.
Inflation was moribund in the West for two decades, with near-zero interest rates since the financial crisis their barely perkier partner.
But we all know that changed in 2022.
Like snow falling in King’s Landing, a bleak inflationary climate is upon us. Every week seems to bring a worse forecast than the last.
Goldman Sachs has just said UK inflation could top 22% by spring unless high gas prices abate.
By the time you read this, its City rivals may have topped even that guesstimate.
We’re not yet buying pints with £50 notes – and we hopefully won’t be anytime soon – but the direction of travel is uncomfortable if you’ve read your economic history books.
High finance
Employees are already pressing for big pay rises – and striking for them like it’s the 1970s – and the cost-of-living crisis is front page news.
But it’s not just as shoppers and bill payers that we must recalibrate to the inflationary times.
As investors, too, we should understand inflation can do funny things to the financial landscape.
So far the biggest impact on most portfolios has been the re-rating of growth stocks.
To tame inflation, central bankers raise short-term interest rates.
Meanwhile market forces lift longer-term interest rates as savers demand higher yields as compensation for inflation eroding the real value of their money.
Far-off company earnings become less valuable when discounted back to present values. Investors have a greater preference for cash today, and put a lower multiple on jam tomorrow.
This shift drove the de-rating in technology stocks we saw earlier this year (exacerbating a sell-off of the Covid darlings already underway as economies re-opened).
It may sound a bit arcane, but Microsoft’s share price is ultimately down for the same reason the price of eggs is up.
And there are other more tangible impacts of inflation that investors should think about.
Ins and outs
So-called value stocks did well initially, as interest rates rose and those growth stocks sold off.
But many value stocks are poorly placed for enduring high inflation.
True, such firms usually churn out cash. Relatively less weight is given to future earnings.
But these companies also tend to have factories, trucks, and other physical assets that require repairs and upgrades to stay in business.
As inflation races higher, these capital and maintenance expenditures climb too.
Sales may rise, but margins are squeezed by the escalating demands on cashflow.
In contrast Coca-Cola’s brand or the Google search engine don’t need rebuilding every few years.
Yet such dominant companies also have the pricing power to prosper with inflation.
Intangible assets do require some maintaining. Coke’s marketing budget is huge!
Nevertheless, as Warren Buffett pointed out in the inflationary 1970s, this dynamic can actually make paying more for capital-light businesses with strong moats preferable if inflation persists.
More or less
At the same time, fast-rising prices can flatter even quality companies’ earnings.
Unilever saw turnover rise 14.9% in its recent first half.
Rival Reckitt’s revenues rose just 4.4%.
At first glance Unilever is knocking it out of the park.
Dig deeper though and you’ll see the volume of goods sold by Unilever actually fell by 1.6% in the six months. Back out currency moves, and most of its sales growth was due to higher prices.
Or, said differently, inflation.
In contrast Reckitt grew volumes by 1.2%. It raised prices but it also managed to sell more stuff.
So which firm is doing better?
To be clear, shareholders of both should be heartened they have demonstrated they can raise prices.
My point is that in the low-inflation era we often applauded even single-digit sales growth.
But high inflation raises the bar.
Accounting for it
There are plenty of other ways inflation may change how you evaluate a company.
High debt at a REIT might be more attractive if it was secured at low long-term interest rates.
Inflation running above 20% would soon whittle away the borrowing burden, while the assets – its properties – should keep pace with price rises over the medium term.
Or how about management performance metrics?
Nominal sales and profit targets are going to be much easier to meet if high inflation keeps puffing up the income statement.
You’ll also need to watch for the impact of particularly critical input prices, such as energy.
Soaring gas and electricity bills could soon cripple low-margin sectors like hospitality.
The high life
If this all seems a lot of extra hassle, spare a thought for managers trying to run their operations.
Indeed for most economists, the biggest problem with high inflation is how much harder it makes forward planning and capital allocation decisions, in both business and daily life. Wheelbarrows of cash are out of fashion in our digital world. But runaway inflation would still be just as burdensome.
