The threat of inflation
Dear investors,
Inflation has returned to the economic agenda both in Brazil and abroad. Although it's a familiar topic for Brazilians, most people only understand its impact on their daily lives: a widespread rise in consumer prices. However, investors should seek a deeper understanding to understand the impact inflation can have on their investments and develop strategies to preserve their assets in inflationary environments.
We will dedicate this letter to this topic. We will explain the main concepts related to inflation and discuss our views on how to conduct investments in the current scenario.
The causes of inflation
The primary cause of inflation is a change in the supply and demand relationship for a good or service. Prices rise when supply decreases or demand increases. With this logic in mind, there are three situations that can be interpreted as triggering inflation.
The first is the expansion of the monetary base, which is the increase in the amount of currency in circulation in the real economy. In short, this is when the government decides to print money. This causes inflation because a country's currency represents the goods that exist in its real economy. Thus, if the amount of money suddenly doubles, while the amount of goods remains the same, the price of everything should also double.
The second cause is a sudden reduction in the supply of a product due to manufacturing, logistical, or other issues. In this scenario, consumers of that product will compete for the limited supply available. Those with greater financial capacity, or who place a higher value on the product, will be willing to pay more to guarantee supply, inflating the overall market price.
The third cause is a sudden increase in demand, linked to an event with a large-scale impact (e.g., the demand for hand sanitizer at the start of the COVID-19 pandemic) or an economic boom, in which several competing businesses aim to grow and compete for the same suppliers.
Having understood the sources of inflation, the next step is to understand how price inflation spreads through the real economy.
How inflation spreads
For convenience, inflation is often discussed as a single percentage, analogous to interest rates, but these two variables behave very differently. In the case of interest rates, the Central Bank publishes the base rate it will use in its own government bond trading, and the entire market quickly adjusts around this rate. In the case of inflation, the percentage we have in mind comes from surveys that measure the price variation of a basket of products and services. It is a more imprecise measure.
To clarify the reason for the inaccuracy, imagine that this method of measuring inflation is analogous to scattering a few thermometers inside a shed and assuming that the temperature inside is the average of all those thermometers. With nothing unusual happening in the shed, this is a good measurement. Now, imagine that a fire is lit in the center of the shed. Until the firewood runs out, the thermometers closest to the fire will indicate much higher temperatures than those further away. It will take some time for the fire to die down, the temperature throughout the shed to become homogeneous, and the readings from the various thermometers will all be close to the new "shed temperature."
From this analogy, it's important to take two concepts into account: i) inflation doesn't spread instantly; and ii) it affects different segments of the economy differently. Think of the different segments as different locations within the shed. On a cold night, you want to be close to the fire, and you don't care what the average temperature is. While the average temperature may indicate a bearable temperature, there may be people freezing to death in the corners of the shed and others very comfortable near the fire.
Looking at the real world, the war between Russia and Ukraine suddenly reduced global oil supply, as Russia, a major producer, suffered embargoes from the entire West. Thus, oil became more expensive while its production costs remained the same, increasing the profits of other oil producers—those who benefited from oil price inflation. Businesses that consume oil on a large scale, however, are in a different position: they may have the power to pass on the price to their own customers, preserving their profitability, or they may be forced to sacrifice profitability to maintain their own demand. However, there is no scenario in which consumers of inflated products benefit.
As a general rule, businesses that are able to raise their prices before facing pressure from their suppliers and seeing their own costs rise are those that benefit from an inflationary environment. Pricing power is key.
Where does current inflation come from?
We are currently experiencing an inflationary cycle triggered by two major events. The first was the pandemic, which had a dual effect. At the same time, it disrupted several production chains, reducing the supply of various products and services, and forced governments around the world (including Brazil) to print money to distribute aid to the population weakened by the pandemic. lockdown. The second was the package of economic sanctions that came into force due to the war between Russia and Ukraine, which restricted the movement of several important commodities, particularly oil.
In this context, inflation is inevitable. The expansion of the monetary base, even in significant amounts, is not an easily reversible movement. Sanctions are reversible in theory, but wars tend to drag on, and the trauma of countries that were most dependent on Russia and suffered from the interruption of trade relations with it has triggered a broad movement of "deglobalization" around the world, the impacts of which are complex to analyze.
Deglobalization can have inflationary impacts in some parts of the world and deflationary impacts in others. If a country heavily dependent on imports decides to limit the number of suppliers it chooses to do business with, its total import costs can only increase. Therefore, this country must increase inflation in its own economy. On the other hand, countries dependent on exports and likely to see their former customers move away will maintain their production capacity and see their demand decline, so their export products must have their prices reduced.
It's very difficult to analyze in detail how each business will suffer or benefit from inflation over time. It's as if fires were randomly popping up and going out in our imaginary shed, and we had to choose the best place to sleep throughout the cold night. Therefore, the best alternative is to focus on the microeconomic analysis of each business and seek to understand which businesses have the power to pass on prices.
The power of pricing
In essence, this power depends on how essential the product or service offered is and how irreplaceable it is. For example, the demand for drinking water is completely inelastic. We would all die after a few days without water, and demand for it is cumulative (going a day without drinking water doesn't reduce your total demand for the week, since the next day you would need to drink more water than usual to stay hydrated). Thus, if there is a shortage of drinking water in a given location, whoever has water would have almost absolute pricing power (until the government appropriates it for the common good). There is no way to measure this pricing power exactly, but it is a point that can be analyzed qualitatively; see the two examples below.
We know there's no viable substitute for oil, and that many sectors are completely dependent on it. Furthermore, oil inventories are small compared to the volume currently consumed. Therefore, it's difficult to postpone oil consumption for long given the current price. This is why oil producers have strong pricing power.
On the other hand, a designer clothing manufacturer could easily be replaced by a manufacturer of cheaper brands if its customers' purchasing power declined. This business would be much more vulnerable in an inflationary environment, having to choose between losing volume or reducing prices, sacrificing profitability.
Since nothing is ever simple in investing, not every business with pricing power will be a good investment. We're focusing on this point due to inflation expectations, but it remains just one of several factors that need to be analyzed before any investment.
Alternatives evaluated
Based on this pricing power criterion, one alternative would be to invest in commodity-producing companies, which would certainly protect us against inflation. However, commodity prices are already quite high, and in many cases, the market already considers these new price levels when evaluating commodity-producing companies. In other words, many of these stocks are not cheap. We don't like the idea of investing in such companies when they are at the peak of their product's price cycle, as there is a significant risk of commodity prices falling in the future, and in this scenario, buying these stocks now could be a bad investment. Therefore, the inflation protection that commodity businesses provide would only be worthwhile if the share prices of these companies were not inflated by optimistic market expectations. We do not rule out the possibility of investing in this type of business, but the prices of the companies we evaluate, for now, are not attractive.
We would also have other ways to avoid inflation risk. We could, for example, allocate more capital to fixed income or real estate funds (although Ártica Long Term is an equity fund, we can allocate up to 1/3 of the fund to other asset classes). So, here's our perspective on these alternatives.
Fixed income doesn't seem like a good idea at the moment. In our 2021 annual letter, we discussed interest rate cycles and stock market performance. In short, periods of high interest rates are the best time to buy stocks, not to invest in fixed income, as this is when stock prices are more attractive. Inflation protection is also not as effective in fixed income, even in post-fixed or hybrid securities (adjusted by the IPCA), as there is a risk of inaccuracy in the official inflation indicator. Some prominent investors have stated that "cash is trash"They refer to the risk of erosion of the real value of money, to which we would be exposed if we left more money in fixed income. In other words, the ideal now is to invest in real assets (including stocks).
Real estate funds seem cheap relative to historical prices, and real estate preserves its value in inflationary environments. However, these funds have become attractive mainly due to rising interest rates, the same reason stocks are also cheap. Comparing the potential return of this alternative with that of the stocks we've already identified, stocks appear to have significantly higher potential returns than real estate funds, so there would be no advantage in allocating capital to this asset class at this time.
Conclusion
We chose to maintain our strategy of gradually allocating our cash, which currently stands at close to 10% of the fund's assets, to good businesses. Pricing power has always been an important criterion for us, as it strongly correlates with the quality and sustainability of the businesses. Thus, many of our invested companies should continue to perform well, even under high inflation. Some of them are exposed to a greater risk of losing demand if inflation is very high for a long period, but this risk is largely offset by the fact that we are buying shares in these businesses at very attractive prices, with an atypically high margin of safety.
We remain confident in our theses, and we express this confidence with our own capital. Ártica's partners and professionals from our Asset Management team are among the people who have invested the most in Ártica Long Term FIA this year. We intend to continue making new contributions over the coming months, following our traditional strategy of distributing our investments throughout the period we consider a good time to invest.
