Inflation is the crux of all markets discussions today. Historically, this has led to the famous growth versus value debate. Some managers believe the recent uptick in inflation could become a secular trend, resulting in a sustained rotation from growth to value style investing. As growth investors, and more importantly as investors in innovation, we disagree.
As with all great debates, there are good, coherent arguments with merit on both sides. These arguments range from high growth-stock valuations, potential technology regulations, to even counterintuitively, better growth prospects for value industries. During the February to May 2021 value rotation, one of the loudest arguments for sustained value outperformance was the potential change to a high-inflation environment. As inflation was such an important factor in this most recent rotation, we are addressing our view on inflation and making a case for a continued low-inflation environment.
The narrative associated with the performance of growth stocks over the past decade is that they have unilaterally outperformed value. We feel that this is incorrect. Periodic episodes of value outperforming growth happen frequently and demonstrate market health. Over the past 13 years, style leadership changed 20 times. However, despite these frequent style rotations, growth has outperformed value by 287 percentage points since 2008! Our takeaways for investors are to stay calm, focus on the long term, and not get distracted by flurry of white noise.
Innovation is deflationary
In human history, we observe episodes of technological innovation interspersed between stretches of negligible growth. Today, we find ourselves in an epoch of accelerated innovation. This quickening of innovation keeps inflation lower by reducing both the costs of goods and the need for human labour.
Innovation drives new ways to produce goods quickly and cheaply. With other factors constant, innovation shifts the supply curve to the right. This increases output while reducing price.
Innovation also creates productivity gains that keep labour costs lower. At the company level, by using leading-edge software, one person can do the work 20 to 30 people did in legacy applications.
Innovations in e-commerce
E-commerce represents a single case study in many innovations impacting retail. Not only is e-commerce deflationary, but some argue e-commerce leads the Consumer Price Index (CPI) to overstating true inflation. CPI measurements may not accurately reflect inflation as they do not incorporate online sales well.
Consumers often find buying products online is much cheaper and there are structural reasons for this. E-commerce makes comparison shopping easy, which can pressure online merchants not to raise prices. In addition, e-commerce stores generally operate with lower costs than brick-and-mortar stores, allowing merchants to sell at lower prices than traditional retailers. Also, consumers can buy products from any geographic location, even locations with a lower cost structure than the consumer’s location
For example, looking at the growth of one single e-commerce company, Amazon, by itself represents the deflationary impact it has. Amazon initially avoided the expenses of brick-and-mortar stores and competed by offering lower prices. As Amazon grew in scale, the company had tremendous bargaining power in purchasing the goods listed on its platform for less, and thus could sell items at a lower cost than most other retailers. As Amazon started operating distribution centres and leasing planes, it removed additional costs from its supply chain. By replacing human labour with robots, logistics algorithms and possibly drone delivery, Amazon should further reduce the cost of delivery and therefore the cost of products sold.
We expect e-commerce’s deflationary effect to grow over time due to lasting changes in consumer behaviour post pandemic.
Growth equities may continue to outperform
We find the value versus growth debate moot. In our view, the best value managers and the best growth managers are all looking for companies that are at a bargain relative to their future free cash flows. In our experience, markets can act like a skittish herd—they can spook easily and run in different directions after a period of relative calm.
The latest growth pullback was driven by concern over inflation from temporary labour shortages that occurred as the economy reopened post-company reorganisations, worker re-evaluations, location movement, and significant government stimulus.
Long-term demand for goods did not change, nor did the ability to manufacture them. If anything, as companies have reorganised during the pandemic, they emerged more efficient, having embraced new technologies and innovations such as video conferencing, e-commerce, simulation software and co-bots, simply to name a few.
We believe growth equities may continue to outperform, looking at history, innovative companies can thrive even in an inflationary environment. Equity market returns are positively correlated with moderate inflation.
Matthew Moberg is portfolio manager of the Franklin Innovation fund. The views expressed above are his own and should not be taken as investment advice.