4 Keys to Navigating Inflation

I’m sure by now you’ve felt the effect of 2022’s high inflation and waves of the stock market. While inflation causes some concern, we can pause and look into what’s triggering inflation. In addition to the increase in gas prices and food costs, there are many contributing factors. There are the lingering effects caused by the disruption of COVID-19, continued supply chain needs, the conflict in Ukraine, and stimulus pumped back into the economy, that all propel inflation. However, there are also aspects that benefit the market as well. Stay with me and let walk you through how to ride this wave of inflation, by reducing costs, staying focused and using this as an opportunity to gain an edge.

Over the last several months, there has been a lot of discussion on inflation and how ‘sticky’ it will be. One of my favorite investors of all time, Ray Dalio has been very vocal about the possibilities of ‘stagflation‘ and how it may impact the global economy.

IF high inflation is here to stay, how can we protect ourselves against its effects? The slow creeping nature of stagflation could be tricky to navigate, but we need to stay ahead of it.

If you see any highlighted words you are not familiar with, you can click them to see a definition at the bottom of the page.

Of recent, the large Fortune 500 companies have experienced recent layoffs in November 2022:

• Amazon announced in a recent blog post that it plans to lay off 10,000 employees, representing 3% of its professionals in corporate and technology roles.
• Twitter has laid off 3,700 employees— almost half of its staff, after Elon Musk’s takeover.
• Meta (formerly Facebook) laid off 11,000 of its employees worldwide.

As this might cause due concern, remember to stay optimistic. There have been mass layoffs like this in the past and the economy has recovered, and it will this time as well.

The 4 Areas of Focus

Our society is fast moving and in a continuous state of flux and advancement with how we evolve and adapt, and that includes where and how we work and earn our money. It’s in times such as these, that we can remain optimistic, tighten our revenue and get creative with additional streams of income.

During an inflationary period, there are four areas of focus.

1. Income Stream
2. Reducing Unnecessary costs
3. Informed Investing
4. Risk Reduction

Let’s dive in.

1 | Income Stream

All of us enjoy our income streams when things are normal. But inflation puts these in danger and most likely will slow down some of these income streams.

Why does inflation slow them down?

Basically, it works like this. When inflation is high, companies must deal with rising costs. Rent and raw materials have all gone up in price. Expenses like these put a damper on profitability. Companies may reduce jobs in order to maintain margins. Job loss in turn leads to lower consumer spending the unemployed may go into debt with their credit cards, credit scores are damaged, dip into their savings. The government will then need to increase aid for unemployment income, welfare, and food stamps. So, the first thing we must do to fight inflation is to protect our income streams.

What can you do to protect your income streams?

For Business Owners

• Be laser focused and engaged on what is happening with your customers and be sure to provide as much value to them as possible. Without customers, you do not have a business.
• Cut any unnecessary expenses: employees, pay off or reduce debts, and re-negotiate lease renewals.

For Employees

• Be the best at what you do – you will always be in demand. There are always ways to improve upon your current skillset, and it is something you should be constantly striving to do.
• Think outside the box (i.e., your cubicle) … your one source of income and BUILD NEW INCOME STREAMS – as Warren Buffett suggests. When you depend on one job for most of your income, you create a single point of failure. Good engineers construct systems with ‘redundancies’ so that a single event does not bring the entire system down. This same idea applies to your income.

2 | Reduce Unnecessary Costs

Inflation will cause ordinary expenses to rise quickly. Rising costs associated with inflation will outpace our income if you do not reduce your expenses.

Be frugal –

So, the second thing we should do to fight inflation is to be frugal. Of course, some of us find it much simpler to adopt a frugal lifestyle than others.

As Charlie Munger said:

Being higher-income earners, there are many among us that live extravagant lifestyles and can find many ways to reduce costs, as opposed to those that are already frugal. If we search hard enough, we can all find a little bit of extra fat to cut. And it is much easier to get rid of this fat before it gets out of hand.

One thing that has helped evaluate my spending is that it must meet 1 of 3 requirements for me:

1. Will it save me time, and does the time savings outweigh the cost?
2. Will it decrease my overall happiness not having this?
3. Is it a luxury (want) or a necessity (need)?

A money-saving tip that has worked for me is to remind myself of the “hedonic treadmill” before buying expensive things. If you are not familiar with this term, it means that you will always return to your baseline level of happiness regardless of what you buy, things that happen in your life, changes that are both good and bad.

3 | Informed Investing

When inflation is high and heading toward possible ‘stagflation,’ investing becomes a little more challenging. That is because we want to put our money into investments that are more stable and less prone to the effects of inflation. And very few investments fit the bill.

This is one of the most important times for you to have an informed opinion and be prepared to deploy capital. Down economies offer many of the best opportunities to invest so being prepared for them with cash on the sideline, can offer a great deal of future returns.

Let’s look at individual stock picking.

The characteristics I like to look for in an inflationary period are:

• Strong pricing power
• Low capital needs

Strong Pricing Power

A business has solid pricing power if it can increase the cost of its goods and services without seeing a decrease in customer demand (i.e., grocery stores and gas stations).

When a company’s products or services are essential to its clients, and there is no suitable alternative, the company will often see a dramatic increase in its share price. These usually fall into the category of ‘consumer staples’ (i.e., Wal-Mart, Pepsi, Proctor & Gamble).

Companies with this kind of pricing power tend to leave clues in their financial statements:

• High operating and gross margins;
• High rates of return on capital invested; and
• High Free Cash Flow conversion, which means that the owners can get most of their money in cash.

These types of companies are favorites of Warren Buffett because they can weather almost any storm.

Low Capital Needs

Capital lightness. Most businesses need capital to make money. Capital includes:

• Working capital includes things like raw materials (inventory), money owed by customers (receivables), and so on.
• Fixed assets, such as factories, warehouses, equipment, etc.

When inflation is high, many companies report more money coming in and more money being made.

But this alone doesn’t make them resistant to inflation. Because a lot of their ‘earnings’ may just go to increasing their capital needs, which they also need to keep spending – to make more money.

So, it is not enough for a business to just raise its prices when inflation happens. It also needs to get a higher ‘return on capital.’ That is, it needs to increase its earnings, to keep up with inflation WITHOUT adding capital, to do so. This is not as easy task for companies.

Warren Buffett wrote a great article for Fortune in 1977 that goes into more detail about this: Buffet, W. (1977). How Inflation Swindles the Equity Investor, Fortune. Click on this link for the full article: How Inflation Swindles the Equity Investor

4 | Risk Reduction

Risk reduction also ties into informed investing. But ‘feeling informed’ may lead to poor decisions as well, especially in the case of black swan events. The greatest investors of all time consistently focus on risk management, even more so than how to invest.

The greatest investors always prepare for the worst-case scenarios – and so should you.

During periods of high inflation, like now, can be particularly dangerous for companies or individuals with high debt. Because we don’t know how long inflation will stick around, it is imperative to evaluate debt with an approach of having reduced income/revenue. This is especially the case for debt that has a variable rate, such as a Home Equity Line of Credit (HELOC) or other variable loans. These types of loans should be reduced as quickly as possible, especially considering the possibility of stagflation. The US and Global Economies have not experienced this type of inflation in over 40 years, and during that time, the money supply was much lower and manageable – things have changed.

For the first time in decades, money managers are advocating that cash (i.e., dollars, or treasury bonds) are actually better to have than stocks. This is the case because of the quantitative tightening, as well as the inflation. Surprisingly, in 2022 the U.S. Dollar Index (DXY)has far outperformed the S&P 500. Now is the time to be moving away from risky assets and stabilize in safer assets until the coast is clear.

Fun fact. Inflation has never been fully curtailed until the federal funds rate at least matched the core inflation number.

Currently, the Core Consumer Price Index (CPI) is 6.3% and the Federal Funds Rate (interest rates) is 4% as of November 2022.

So, if inflation does not subside quickly, expect interest rates to keep going up.

Conclusion

In summary, during this period of temporary economic decline, stay calm and laser focused on:

1. your income stream and be creative – generate ways to create multiple sources of income;
2. be frugal, review all of your expenses, make cuts and reduce your spending habits;
3. be informed about your investments, trust your intuition, use this as an opportunity, take charge; and
4. reduce your risks and prepare for worst-case scenarios.

Definitions

Stagflation is an economic cycle characterized by slow growth and a high unemployment rate accompanied by inflation.

Quantitative tightening (QT) refers to monetary policies that contract, or reduce, the Federal Reserve System’s balance sheet. Resulting in less money in the economy.

The Federal Funds Rate is the target interest rate set by the Federal Open Market Committee (FOMC) which is the rate commercial banks borrow and lend their excess reserves to each other overnight.

The Consumer Price Index (CPI) measures monthly changes in prices paid by U.S. consumers.

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