Jeff D. Opdyke
You’ve probably seen the meme asserting that “2 + 2 = 5 … at extreme valuations of 2.” It’s just a way of debunking assumed truths while pointing out that, in certain situations, conventional wisdom disregards other possibilities to its own detriment.
Which bring us to inflation…
Conventional wisdom – and historical precedent – says that when inflation ramps higher (and it will), the Fed will respond by jacking up interest rates. And maybe that’s true. But what if this time we’re at extreme valuations of two? What if this time, instead of four, we get five?
What if we get high inflation … and low interest rates?
The two seem incompatible. And yet India is living through this right now, with inflation rising unexpectedly, even as aggregate demand is falling and the Reserve Bank of India is cutting rates.
There’s a case for the same script to unfold in America.
As Reuters recently reported: U.S. consumer prices in July “rose more than expected [with] underlying inflation increasing by the most in 29 1/2 years.” Is that a harbinger … or a fluke?
At the same time, all the money Congress and the Fed have been splashing out to save consumers and the economy from the coronavirus now has US debt-to-GDP approaching 154%. That’s exceedingly large, and it raises legit questions about the Fed’s capacity to raise rates.
As it is, the US already issues debt just to make payments on its existing debt. Rising rates would mean the cost of managing America’s nearly $27 trillion in existing debt would rise too. The Fed is not unaware of this, and could face a situation where needs low rates just to maintain America’s ability to afford its life in hock.
So … a high-inflation, low-rate world.
How to invest if that environment emerges?
The current belief that financials would benefit from rising inflation could be shot full of holes. Cost pressures would rise, the value of loans repayments would decline as inflation erodes those future dollars the banks are due, and yet banks wouldn’t have higher interest rates to push up their interest income and offset their income pinch.
The real winners: Companies with pricing power that are not reliant on consumer spending.
In a word: healthcare.
Though co-pays and deductibles certainly touch the American pocketbook, government programs and private insurers primarily foot US healthcare costs. As such, consumers in a bad economy don’t put off medical care and prescriptions to the same degree they might put off, say, a car repair. That gives various healthcare companies – from for-profit hospitals to medical-device makers to pharmaceuticals – some degree of pricing power and unending demand.
Thus, healthcare seems pretty well insulated from a 2 + 2 = 5 world.
One could cherry-pick a few individual names to buy, and that’s not a bad approach. But in this particular instance, a broad-spectrum ETF seems a sounder strategy. Own every boat that rises with the tide, rather than just a few.
Health Care Select Sector SPDR ETF (XLV) and Vanguard Health Care ETF (VHT) both fit the bill. They each own an identical portfolio of insurers, pharma, biopharma, medical-device makers and such. And their internal metrics are near-siblings of one another. Picking between either is, frankly, a coin flip, but I’ll lean into Vanguard, if only because it has a slightly lower annual fee, and marginally better long-term performance. And in the world that’s likely headed out way, eeking out a few extra bips will mean something.
Perhaps the real benefit: Even if we get the status quo and two and two are four, healthcare has the exact same tailwinds. So it’s like you’re tossing dice here and hoping to make the number – whether that’s four … or five.