How Inflation, Deflation Impact Disruptive Growth Investing

The arrival of the new year brings optimism that disruptive growth investing will rebound after a depressing 2021.

There's also apprehension as chastened clients ponder what went wrong last year. Aided by the coronavirus pandemic, stocks with the disruptive and innovative labels thrived in 2020 while the related funds hauled in tens of billions of dollars of new assets.

Broadly speaking, the inflows continued last year, but that amounted to buying high as many disruptive growth strategies flailed even as traditional growth benchmarks delivered for investors. A big part of the reason disruptive growth languished in 2021 is that the style start the year stumbling due in part to the resurgence of cyclical value stocks.

Fueled by rising inflation, cyclical value stocks thrived through much of the first half of 2021 while the related rise in 10-year Treasury yields sapped disruptive growth fare. Innovative growth names had some moments in the sun in 2021, but as it became apparent inflation wasn't transitory, this investing style fell out of favor.

Simple Explanation and Opportunity

As advisors know, it's easy to convey to clients why previously beloved disruptive growth fare fell out of favor last year.

“Associated with strong economic cycles, inflation tends to benefit 'value stocks,' particularly energy, financial services, industrials, and materials,” says ARK Investment Management CEO and CIO Cathie Wood. “At the same time, by raising discount rates and lowering the present value of future cash flows, higher interest rates tend to hurt long duration assets like aggressive growth stocks.”

In simple terms, many disruptive growth companies are sacrificing profitability to invest in and capture growth today and invest for the future. That pushes cash flows out – in some cases years – and it's usually unprofitable companies that are most vulnerable to inflation.

While the typical reaction by central banks to inflation is to boost interest rates, Wood argues the bond market may be telling the Fed to not do that.

In her wide-ranging report dated Dec. 17, the ARK boss says, “the bond market seems to be warning the Fed not to tighten. Since February, the yield curve as measured by the difference between the yields on the 10-year Treasury bond and the 2-year Treasury note has flattened from 159 basis points to 80 basis points, pointing to the rising probability of recession, lower inflation, or both during the next year.”

Where Deflation Fits In

At a time when inflation is a high as it's been in four decades, thinking about deflation is admittedly difficult, but it's a reality advisors should prepare clients for.

In fact, positive deflation is accretive to the disruptive growth thesis. As disruptive companies refine production processes, costs decline. That means disruptive concepts and technologies are accessible to a wider client base at more favorable price points. In turn, older, obsolete products and technologies go on sale, igniting the flames of deflation. Artificial intelligence and robotics are good examples of good deflation at work.

“Moreover, artificial intelligence training costs are declining at a rate of 60% per year. Provocatively, these platforms are converging, creating the potential for more dramatic cost declines as S-curves feed and reinforce one another,” notes Wood.

The reality is many industries as clients know them today are going to be disrupted and clients can participate in that trend. Some positive deflation certainly bolsters the case.

Related: There Might Be Value in Disruptive Growth