After Inflation, Deflation Won't Be All Bad News

Due to the gravity of the global financial crisis, it's often forgotten that 2006 was a good year for stocks. The S&P 500 returned 13.8% in 2006,

With the benefit of hindsight, we now know all was not right in 2006 and with that in mind, the old saying about market history not always repeating but often rhyming is worth remembering today.

“Once again today, commodities prices have been soaring while bond yields are slipping. Oil prices have more than tripled from less than $20 during the depths of the coronavirus crisis in April 2020 to $63 today while bond yields have settled down after the equivalent of a 'heart attack,'” says ARK Invest Management CEO and Chief Investment Officer Cathie Wood in a recent note.

In the first quarter, 10-year Treasury yields nearly doubled, the most rapid occurrence of that scenario on record, while fueling the rotation to cyclical value stocks. Obviously, that's pressuring growth stocks, but that segment isn't down on the year – it's merely lagging value. That could be a sign that if inflation proves transitory as many market observers are betting it will be, disruptive growth strategies could come back into style.

Could Inflation Turn Into Deflation?

With the world awash in easy monetary policy and the U.S. home to profligate spending, it's not surprising that advisors are fielding more and more inquiries about the specter of inflation. Undoubtedly, rising consumer prices are meaningful and can have profound effects on client portfolios, but if inflation proves fleeting, it could rapidly give way to deflation.

As Wood points out, deflation could be a good news/bad news scenario. Companies that have been catering to short-termism – those acquiescing to investors' demands for buybacks and dividends rather than spending on research and development – could be vulnerable in a deflationary environment.

Those firms, some of which already have sub-par balance sheets, may be compelled to dramatically lower prices on sagging products to reduce inventories if deflation comes to pass. However, disruptive growth companies dedicated to research and development and expanding market share could reward clients if deflation arrives.

“Other companies have been preparing for the exponential growth opportunities emerging from the five major innovation platforms that we believe have hit escape velocity,” says Wood. “Many have sacrificed short-term profits to move into pole positions, harnessing artificial intelligence and capitalizing on what could be winner-takes-most opportunities.”

Deflation Could Be Catalyst for Disruptive Investing

For those that can see the forest through the trees – something advisors should do on clients' behalves –  it's worth considering that while previously exhilarating emerging growth fare is sagging due to the value rotation, that rotation is actually efficacious for disruptive growth investing because it serves to extend the bull market.

In fact, disruptive growth could easily come back into fashion because deflation would likely weigh on GDP growth, forcing cyclical stocks out of favor.

“If we are correct in our assessment that the risk to the outlook is deflation, not inflation, then nominal GDP growth is likely to be much lower than expected, suggesting that scarce double-digit growth opportunities will be rewarded accordingly,” concludes Wood. “Growth stocks in general and innovation-driven stocks in particular should be the prime beneficiaries.”

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