Posted by: donmihaihai | July 11, 2022

Inflation, interest rate and valuation

We all know about the current inflation but what causes inflation? My limited understanding, not the academy definition, is that it is either cause by cost inflation or money printing or both.

How do I know which is which? I think the answer is pretty easy. Because of trade, cost inflation will be felt by all countries, how much the degree will depend on the structure of each country. As for money printing, it will be country specific. If Singapore is printing lot of money, then SGD will lose it purchasing power over time, same amount of money will buy less and less stuffs. But it doesn’t affect Malaysia because Malaysian uses MYR not SGD.

Side track to printing money. It is actually not an act of printing real money. ie money in circulation. Not any more. Money in circulation will always be way less than total money. Well, I certainly has more money than the SGD in my wallet and don’t receive money from my government through mail, it goes right into my bank account. And below is a chart of extreme money printing on exchange rate. So while it is common to point at US for printing lot of USD, my question is why USD still trade within range of all major currencies? The answer will be either a) US haven’t been printing money or b) all major countries are doing some sort of money printing. I choose b) of course.

Since I think the current inflation is due to cost, it will end with cost is under control. A little inflation won’t kill.

Interest rate follow inflation, how closely, i don’t know but I would be surprise if it doesn’t. I think some basic will be if you are talking loan for housing and expect interest rate to go up, you should go for fixed rate but when you are putting money in FD, then short term FD is the way to go. I see people doing just the opposite. Maybe I am wrong and inflation and interest rate are dropping from hereon.

Now the most interesting part. Valuation when you have higher inflation and interest rate. The short answer is just what WB said, interest rates are like gravity to valuation. But before that, let talk about how higher inflation and interest rate impact on business.

For inflation, it will pass through companies over time, how fast or slow will depend on industry specific. If retail rental is in over supply situation, then it doesn’t matter what other say about property being inflation hedge, the landlord will not able to increase rental until demand supply balance itself and at the same time, other cost such as employees, HQ bills, etc will be going up. Now company specific, if a REIT is in similar situation with substantial debts, then cost of debt, ie finance cost will increase as well. If interest coverage is 5X and finance cost double, profit drop by 50%, if interest coverage is 2X and finance cost double, profit drop by > 100%. Companies who extended itself in low interest environment will entered a high interest rate environment in a very bad shape.

A REIT don’t usually construct a new retail mall, just assume that it does because there is demand, then it will need to spend more on Capex as a mall cost more after all these inflation with less profitability. So stronger companies will standout in whatever environment but they are just the second best. The best companies are those with pricing power without the huge capex needs.

How much you are going to value these companies? I would pay less even for the best companies in this environment. Paying 3X BV for a company with ROE of 20% sound expensive at a 5% interest rate environment even if the company has pricing power without huge capex needs but it will not be as crazy as buying a REIT at say 6 to 7% current yield, ie without taking the increase in finance cost into consideration.

Generally, in a higher inflation environment, stock valuation will be way lower, especially compared against the recent history. I am looking forward for it and it might be a long wait.

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