3 Stocks to Buy for Rising Inflation and Slowing Growth

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The post 3 Stocks to Buy for Rising Inflation and Slowing Growth appeared first on Millennial Money.

What happened to the stock market’s rally? Through the end of August, both the S&P 500 and Dow Jones Industrial Average exceeded full-year returns in 2020. The S&P 500 even reported 53 record closes through August, putting it on pace for the most record closes ever.

But we all know stocks can’t go up forever and quite a few investors were expecting a September sell-off. That’s understandable: since 1950, all major indices have averaged negative returns during the month in what’s known as the “September Effect.” In a case of history repeating itself, the Dow Jones dropped 4.3% and the Nasdaq fell 5.3% last month.

However, it wasn’t a market anomaly that led to the September sell-off, but rather increasing fears of “stagflation”—rising inflation and slowing growth.

3 Stocks to Buy for Rising Inflation

Here are three stagflation stocks to buy this fall.

McDonald’s
JPMorgan Chase
ExxonMobil

McDonald’s (NYSE: MCD)

The inflation-proof, unique business model of McDonald’s

McDonald’s (NYSE:MCD)
Price: $238.44 (as of close Oct 21, 2021)
Market Cap: $180.277B

Although shares are up more than 110% in the last five years, McDonald’s Corporation is well situated to outperform the market in a stagflationary environment. To understand its rare opportunity, it’s important to properly understand their business model.

Most investors believe the company is a restaurant operator when they are really a restaurant franchisor and, more aptly, a real estate juggernaut. In the United States, approximately 95% of all restaurants are franchised, and those franchises provided 60% of the McDonald’s revenue and a whopping 85% of its margins in the most recent quarter.

The difference is key when you consider a stagflation environment. McDonald’s charges its partners both rent and a royalty that are paid for in the form of a percentage of sales. According to the Service Employees International Union, these two charges total 15% of gross sales.

Gross sales are the key words above. McDonald’s revenue from franchises is based solely on the top number—not on profit. That means the company’s business model mostly avoids the cost of higher labor, food, and packaging in its cost of goods while price increases by its franchisees are directly captured by the company. Simply put, the company is a winner in an inflationary environment!

McDonald’s doesn’t want its franchisees to suffer and adds value to its restauranteurs in the form of its strong domestic supply chain and buying power. As a result, McDonald’s will be able to keep food inflation in check and avoid stock-outs for its franchisees more than mom-and-pop restaurants. It’ll also avoid food inflation in contrast to grocery store prices, which makes it a more affordable option than competitors and consumer substitutes like cooking and eating in the home.

On a competitive basis, fast food is in a sweet spot during a stagflationary environment. Rising prices at higher-cost fast-casual restaurants will benefit a cheaper option like McDonald’s.

Full-service restaurants that depend upon more waitstaff and other labor providers will be understandably challenged when pitted against a QSR giant like McDonald’s. Stagflation, as defined by rising labor and product costs along with consumers carefully watching their wallets, puts McDonald’s in a rare sweet spot in the restaurant industry.

JPMorgan Chase (NYSE: JPM)

JPMorgan Chase is a best-of-breed pick in a strong industry

JPMorgan Chase (NYSE:JPM)
Price: $171.78 (as of close Oct 21, 2021)
Market Cap: $500.923B

Mark Twain once quipped, “history doesn’t repeat itself, but it often rhymes.” If we’re hit with a bout of stagflation, look for best-of-breed financial institution JPMorgan Chase & Co. to benefit from policy decisions.

In 1979, a year in which inflation ran 11.3%, President Jimmy Carter appointed Paul Volker to run the Federal Reserve to “slay the inflation dragon.” Volker’s Fed did the unthinkable, pushing federal interest rates briefly above 20% (mortgage rates reached as high as 18.5%)!

While it’s unthinkable to believe that rates will have to be raised anywhere near that level, what is clear is higher rates help banks across the board.

Conceptually, it’s easier to think of banks as “spread managers” in their core banking functions. They pay depositors interest on their short-term checking and savings accounts, while lending the money out at higher rates for longer-dated car, home, and personal loans.

The difference earned between these two rates, or spread, is what’s referred to as net interest income. Because rates tend to rise more with duration (length of loan), banks generally benefit from rising rates as the net yield expands.

For the last few years, the exact opposite has occurred, and JPMorgan has seen its net interest income continue to decline. In the quarterly report released this week, the company announced that it expects net interest income of $52.5 billion, down $2 billion from the prior year on account of continued falling rates.

However, in a bout of good news, this figure beat analyst expectations during the quarter as the recent uptick in rates helped results. As rates increase across the board—as they have been in recent months—look for JPMorgan’s net yield to rise and for the stock to benefit.

Stagflation isn’t all good news for JPMorgan. Slowing economic growth could hurt both the company’s corporate and personal loan portfolio, if loan defaults pick up, along with non-interest activities like IPO and bond underwriting. The latter of which is becoming increasingly important: as of the recent quarter, non-interest revenue was 56% of JPMorgan’s total top line.

However, the bank has its pick of the best borrowers with strong personal balance sheets. As such, JPMorgan’s loan portfolio will hold up significantly better than regional and local banks.

As a bank, the company will mostly be inoculated from rising costs due to global supply chains and other input cost increases. The financial sector should do well in an inflationary environment, but JPMorgan remains a best-of-breed pick in the sector.

ExxonMobil (NYSE: XOM)

ExxonMobil still has room to run

ExxonMobil (NYSE:XOM)
Price: $63.12 (as of close Oct 21, 2021)
Market Cap: $265.402B

Let’s get this out of the way: ExxonMobil’s execution has been lacking for years and shares now sit 20% lower than they did a decade ago. The company has been faulted for being slow to embrace green energy and doubling down on fossil fuels, which have become more expensive to extract and discover while prices remain stagnant.

The last few years have seen the limits of Exxon’s myopic strategy. In the last year, management had to issue billions in debt just to pay its dividend and maintain its status as a Dividend Aristocrat. Even so, it still lost an embarrassing board proxy vote against small activist investor Engine No. 1, despite the latter only owning 0.2% of Exxon shares.

Still around? Good. Against that backdrop, you might not expect that ExxonMobil is one of the best-performing stocks in the S&P 500 this year as shares have advanced nearly 50% year-to-date (on top of a juicy 6% dividend yield).

The company is taking advantage of the recent reversal in natural gas and oil prices, both of which have doubled in the last one-year period. Commodity producers like oil have a long history of being able to outperform in an inflationary environment and this time is no different. Simply put: your pain (at the pump) is Exxon’s gain.

There are reasons to believe oil prices will remain elevated. As noted earlier, the stagflation of the 1970s derived from oil shortages and price spikes when a faction of OPEC countries decided to embargo exporting oil to the United States for political impact.

For different reasons, OPEC again decided to limit production for price stability last year amid plummeting demand. While there has been some agreement to raise production levels, OPEC appears to want to keep prices at higher levels to make up for lost revenue during the pandemic.

The winners under this scenario are the large integrated majors like ExxonMobil that can take advantage of all facets of rising prices for oil, gas, and the various chemical distillates. In the second quarter the company reported a $4.7 billion profit—a significant improvement over the $1 billion loss in the year-ago period. While its debt level remains elevated, it appears Exxon is out of the woods and will be able to continue paying its dividend.

It’s unlikely ExxonMobil will experience the negative effects traditionally associated with stagflation. Normally, a slowdown in economic activity would result in less demand for oil, but the pandemic wasn’t a normal economic environment. America and the world will continue to reopen and resume travel, which should rise from current lockdown-era levels even if the economy slows.

Instead, the biggest argument against ExxonMobil is that the company missed the boat on embracing clean energy and new technologies like EVs will impact future results. While admittedly this would be a positive for the environment and climate change, the simple fact is a shift away from fossil fuels will take much longer than most people expect.

In fact, the International Energy Agency estimates that the global demand for oil could rise to 104.1 million barrels per day in 2026, up 8% from 2021 levels. And even then it isn’t that demand will crater. Instead, experts forecast a plateauing and slow decline from 2030 onwards. This gives ExxonMobil ample time to pivot to new means of energy production. And the company has the scale and knowledge to buy or build a clean-energy business.

That 70s market

Stagflation might sound funny, but the consequences are serious. The word is a portmanteau for slow/sluggish growth, aka stagnation, and inflation. This condition doesn’t happen often—most recently in the 1970s—but the latest conditions are hinting at a return.

After the consumer price index rose at a 5% (or more) annual clip for four straight months, Fed Chair Jay Powell admitted inflation has been elevated longer than anticipated. At the same time, growth forecasts continue to be downwardly revised, most notably by Goldman Sachs—its third consecutive month of cuts.

In a nutshell, stagflation is bad because policy choices are limited. Normally, inflation and economic growth move together, which makes policy choices directionally in alignment—under stagflation, they aren’t. This makes policymakers choose between raising rates to beat inflation, which further limits growth, or letting inflation continue to spiral in hopes the economy will pick up.

If history is any indication, stagflation could continue for the foreseeable future. The stagflation of the 1970s was driven by a “supply shock” of steepening oil prices (at that time, we were more dependent upon imported oil). The good news is that we now produce more oil and natural gas domestically (see: stock No. 3), but the downside is we manufacture much less of everything else we consume.

The import supply chains broke during the COVID-19 pandemic and we’re now in a situation where thousands of ships full of goods are piling up at ports. Therefore, our “supply shock” isn’t just oil but everything else and it’s unlikely our Federal Reserve can fix this through monetary policy, at least in the short run.

Stagflation Returns

We’ve established that stagflation is terrible for the economy, but what about investing?

As you might have noticed, stocks don’t always follow the economy (the pandemic being a recent and salient example). Economic activity fell off a cliff while the stock market exploded. Meme stocks like AMC Entertainment and GameStop continue to struggle operationally but have seen their stocks “moon” as message board traders buy shares hand over fist.

Unfortunately, stagflation isn’t one of these times. The chart below gives returns for the S&P 500 during the years 1973-1982, generally known as the stagflation era. At first glance, the S&P 500 returns are on the lower side with an average yearly return of 3.6%.

Considering inflation during the average year was 8.8% during that period, the real return (read: returns above the level of inflation), this was one of the few long-term periods in American history in which stocks did not beat inflation.

If one considers inflation as the “hurdle rate” of returns—which makes sense because the key reason to own stocks is to offset the impact of inflation—the stagflation era was a terrible period for stock returns.

Put another way: the S&P 500 not only underperformed its long-term growth rate of 10%, but shockingly provided negative real returns in half of the decade!

If you feel stagflation will continue, it’s clear you must be smart with your investments. At a high level, it’s a good idea to avoid stocks that are highly exposed to global supply chains and economically sensitive companies unable to pass along rising costs to consumers.

This is why we recommend these companies with strong brands and revenue models aligned with inflation. They could be savvy investments for our stagflationary times.

The post 3 Stocks to Buy for Rising Inflation and Slowing Growth appeared first on Millennial Money.

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3 Stocks to Buy for Rising Inflation and Slowing Growth

3 Stocks to Buy for Rising Inflation

McDonald’s (NYSE: MCD)

JPMorgan Chase (NYSE: JPM)

ExxonMobil (NYSE: XOM)

That 70s market

Stagflation Returns

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