Biogen approval is not without risks; what benefits from inflation?

The news was big and caused a positive spillover effect into our NextGen Medicine basket, which also consists of biotechnology companies researching antibody therapy drugs. Other growth pockets in US equity markets such as bubble stocks and e-commerce also gained yesterday on the general rise in sentiment. While the FDA is potentially a landmark decision and key milestone in treating Alzheimer, there is still risk that the drug will not get the final approval. The next weeks will show whether the market believes in the drug or not.

The winners and losers from inflation

Since 8 November 2020, inflation expectations have risen dramatically reflecting a much faster reopening path due to effective Covid-19 vaccines. With rising inflation expectations, the discussion about transitory vs. permanently higher inflation rate has raged among investors and economists. Consensus still bets on transitory inflation, while we are leaning towards more permanent inflation driven by historical stimulus not seen in size since economic records began after WWII. If we are right that the world economy is flirting dangerously with inflation dynamics that could drastically counter the trend in inflation over the past three decades, equity investors must be prepared. So, what gains and losses during inflation?

If look at our theme baskets and how they have performed since 8 November 2020, we see a clear tendency. Companies operating in the physical world have gained the most with themes like India, logistics, and commodity sector being the best performing themes, while China consumer & technology, gaming and bubble stocks themes have done worst.

Aswath Damodaran, finance professor at NYU, has created this excellent graphics showing how inflation impacts equities. Higher inflation lifts nominal GDP growth and thus creates higher growth rates across all industries and thus also higher future cash flows. The operating margin is determined by the company’s market power and cost efficiency, and input costs which do not hit equally all companies as inflationary pressures have varying size in an inflation cycle. Higher growth also leads to higher need for investments (capex) which subtracts from cash flows to free cash flows available to shareholders or creditors. However, while higher growth leads to higher cash flows and thus higher equity values, the discount rate subtracts from these cash flows. The discount rate is a function of the risk-free rate and an equity risk premium. For now, the risk-free rate has not followed inflation expectations measured in markets, hence consensus is betting on inflation being transitory, and has recently settled around 1.6%. The risk premium on equities has declined recently (but could rise significantly if inflation sticks above 3.5%), and when factoring in these two developments the rising discount rate has not offset the higher growth expectations and thus equities have risen to new all-time highs.