After seven consecutive months of relative calm and uninterrupted gains this year, September has proven once again to be a challenging month for the market amid higher than expected inflation and a political showdown in Washington. That’s often how it happens, you have quiet and complacent markets and then a gut check. As long-term investors, our job is to look through the short-term market disruptions and instead focus on the long-term implications for company valuations.
Regarding Washington, we adhere to the adage that you should always expect the unexpected, and the fate of the two proposed infrastructure plans are no exception. As with any major initiative out of D.C., these plans have been in intense negotiations between the Democratic and Republican parties. The most likely outcome is the passage of some but not all of the proposals. The impact of the “traditional” infrastructure plan on stocks would likely provide a boost to a wide range of sectors while the larger “social” infrastructure package that includes higher tax rates might be a headwind for further valuation increases.
Americans are rightfully concerned about rising prices for food and consumer goods. The Consumer Price Index (“CPI”) recently recorded the largest increase since 1990. Commodities, including energy, grains, and livestock, are much more expensive. Meanwhile the global supply chain itself has become a bottleneck, as we recently noted. While the spike may prove transitory, experience has taught us that inflation can be stubbornly persistent for longer than expected and therefore cannot be ignored.
Historically, stocks have consistently increased long-term investors’ purchasing power thanks to businesses ability to raise prices and create new sources of value. Over rolling 10-year periods measured quarterly, the S&P 500’s return has beaten the CPI in every era dating back to the 1950s, except for the mid-1970s when high inflation reigned. Notably, small company stocks have outperformed large cap shares in periods of rising inflation, and were some of the best performing assets during the 70s.
Amid the current environment, businesses from Costco to FedEx have been able to pass the higher prices they are paying for goods and services on to consumers without encountering resistance or losing market share. Dollar Tree announced that it would start selling products above $1 in response to supply chain snarls, a tight labor market, and inflation. The ideal companies to own are the ones that can pass along higher costs to their customers because of strong demand for their products. In addition to pricing power, we favor companies that regularly boost the size of their dividends. The bigger the increase over time, the greater the chance of outpacing inflation.
Inflation can be insidious for bond investors, whose fixed interest payments increasingly lose purchasing power and whose bond prices often decline as interest rates rise in response to inflation. With cash yielding little to nothing and inflationary pressures mounting, clients should remain more fully invested. If clients must diversify equity risk, we continue to recommend high-quality, short maturity bonds.
With inflation percolating, we continue to find well-managed companies at reasonable valuations with strong competitive advantages in industries with high barriers to entry. Small cap and non-U.S. stocks continue to represent good values. It is well understood that investing at lower starting valuations has historically provided better returns over the long-term. Lastly, we remind clients to maintain a diversified asset allocation and long-term perspective.
We continue to wish you good health and encourage you to reach out for any support you may need. Thank you for your trust in Cardinal Capital.