Warren Buffett: How Inflation Will Impact the Stock Market (2021)

It's no secret that inflation is top of mind for investors right now, as prices for housing, lumber, copper, steel, and countless other commodities and goods increase at the fastest rate in years. It is natural for an investor to wonder how inflation can impact the stock market and the economy. This raised two very important questions for me that I need to learn more about:

Number one, how does inflation affect the future returns of the stock market? And two, how will inflation impact the stocks that I own within my portfolio?

To learn more about this, I turn to a pair of investors that have lived through countless economic cycles and periods of elevated inflation: the legends themselves, Warren Buffett and Charlie Munger. Now, let's take a look at these two clips of Warren Buffett and Charlie Munger in 2003 and 2019 explaining how inflation impacts the stock market, as they are just as relevant now as ever before.

Make sure to like this video and subscribe to the channel if you aren't already, because my goal is to help you learn about investing and the stock market by selling the world's greatest investors. Enjoy the video.

Good morning. Good morning. My name is Matt Sauer and I'm from Durham, North Carolina. In a 1977 Fortune magazine article titled “Inflation Swindles the Equity Investor,” you argued that corporate earnings in aggregate acted like a bond coupon and thus were negatively impacted by high inflation. Due to high inflation at the time, you posited a world where a twelve percent return on corporate equity would be reduced to seven percent after taxes and netted out to zero percent in real terms.

You have been sounding downcast about the prospects for equities for several years, much of which we assume relates to extreme starting valuations. If inflation was decidedly bad for investors in 1977, isn't the relative lack of it in today's economy at least one mark in the plus column for equity owners? Is there also a future inflation expectation component in your warnings that investors are likely to be disappointed by equity results?

Well, I would… there's no question that the lack of inflation is a plus for owners. I mean, the real return you will obtain, in my view, from owning American business, if purchased at similar prices, will be higher if we have long periods of low or close to no inflation than if we had long periods of high inflation.

I don't think there's any question about that because that article went on to explain how he got taxed on nominal returns and fictitious returns in real terms. So your question about which period is better for investors—a low inflation period over any long period is better for investors.

The problem, as you pointed out, also was the starting point in terms of predicting modest returns for equity investors. The returns weren't necessarily so modest; particularly, they were just modest compared to what people had begun to think returns would be during that long bull market from 1982 to 1999. There were polls taken by Gallup working with, I think, Payne Weber at the time, now they've moved it over to UBS Warburg, that showed the expectancy of people in the stock market, and those returns that people expected got up to 14 or 15, as I remember.

They were thinking they were going to get 14 or 15 in a low inflation environment. Well, that, you know, that was dreaming. And there's nothing wrong in a low inflation environment at all in earning, you know, six or seven percent. That's probably as well… well, it is, as good as going will happen because in a low inflation environment, how much is GDP going to grow?

Well, GDP, you know, if you have a two percent inflation and even three percent real growth, you're talking about five percent in nominal terms GDP growing. If GDP grows at that rate over time, corporate profits will grow more or less at that rate. And if corporate profits grow at five percent a year, the value of those corporate profits, the capitalized value will probably grow at something like that over any long term, with a sort of a normal starting point.

And add that to dividends, and you know, you will get six or seven percent before frictional costs. Investors incur a lot of frictional costs; they don't have to, but they do, and that often is one and a half, two percent of their investments.

So the math isn't bad; it's just bad for those people that got used to or expected very high returns based on looking in the rearview mirror back in 1998 or 1999.

Charlie, my general attitude is just slightly more negative than Warren's.

You've heard it, folks, that isn't the end of the world. I mean, in effect, if the people who own American business get five to six percent of the pie—a 10 trillion dollar economy now, someday a 20 trillion dollar account—but if we get five or six percent of the pie, those of us who put our capital out to produce goods and services for American business, for American consumers, for the American population, is that a… you know, I don't know whether that's exactly what somebody who designed the universe would come up with, but it doesn't strike me as crazy in either direction.

You know, I think that that's a lot of goods and services to go to people that put up the capital. But you've got, you know, 100 million-plus people in the working force that are working to turn that out for you using your capital, and it provides what I would regard as a pretty decent real return if you have low inflation.

If you get into high inflation, as I wrote about back in ’77, you could easily have the real return to investors get to a very, very low number, and perhaps negative. I mean, inflation can swindle the equity investor, as I wrote back then, and I used 7,000 words to explain why. I will be glad to send you a copy of that article if anyone's still interested.

But inflation is the one thing that over a long period of time can turn investors' results in aggregate into a negative figure, and it's the investor's enemy.

Charlie, does that bring forth any further thoughts?

I don't think you'll get perfect help on these subjects from the economics profession either. They have certain standard formulas. To an economist, when a manufacturing job goes to China, that's just so much productivity increased. And if you ask one, "Well, suppose all of the manufacturing jobs in America went to China, wouldn't that be a little too much efficiency increase?" And the answer would be, "No."

This question comes from Mark Jordan in Charleston, South Carolina. He writes, "In a period of high inflation, which particular business owned by Berkshire Hathaway will perform the best and which will perform the worst, and why?"

Well, the businesses that will perform the best are the ones that require little capital investment to facilitate inflationary growth and that have strong positions that allow them to increase prices with inflation. And, you know, we have a candy business, for example, and the value of the dollar since we bought that candy business has probably fallen at least 85 percent, I would say 80 to 85 percent.

And that candy business sells 75 more pounds of candy than it did when we bought it, but it has 10 times the revenues, and it doesn’t take a lot more capital. So that kind of a business—any business that can has enough freedom to price to offset inflation and doesn't require commensurate investment, or a huge investment to support it, will do well.

Businesses like our utilities, which get, in effect, a bond-like return, but require, you know, if you're going to build a generating plant that costs twice as much per kilowatt hour of capacity, and all you're going to get is a fixed return, and yields on bonds go up perhaps dramatically to get high inflation, is not going to do that well in an inflationary period just because it has certain aspects of a bond-like investment, and bonds generally are not going to do well in inflation.

Charlie?

Well, but like our insurance operations, our capital-intensive railroad business is certainly one of the best railroads in the world, and our utility operations are certainly one of the best utility operations in the world.

So it isn't all bad to be up there world class in your main businesses. Our railroad—the government’s talked about building a high-speed rail system in California. I think they're talking about 800 miles of track, and their estimated cost was about 43 billion.

Estimated costs on constructions and things like that go up dramatically much more often than they get reduced, even by a minor amount. And of course, we paid 43 billion, counting debt assumed, for a rail system which has 22,000 miles of main track and 6,000-plus locomotives and 13,000 bridges if you ever want to buy a bridge.

So the replacement value of that asset during inflation already is huge, and it would grow dramatically. The world—our country will always need rail transportation, so it is a terrific asset to own. I'll just leave it at that.