Money serves many functions, but perhaps the most important one is that of preserving wealth.
When money supply increases, however, we have the phenomenon of too much money chasing too few goods (a paraphrasing of Milton Freidman’s axiom of inflation always and everywhere being a monetary phenomena).
If we look at the narrow definition of money supply, (M1), it effectively doubled during the Covid period and unsurprisingly the effect was inflation. On a side note, it is surprising that in an age where we espouse that ‘cash’ doesn’t matter, we seem to be having more and more of it.
In the UAE, M1, which had been largely stable at around Dh450 billion till the end of 2017, increased to Dh738 billion by the end of 2022, largely driven by the Federal Reserve’s QE program. In a complex system, we can introduce other variables such as supply disruptions and hoarding, but these issues mask the underlying driver of monetary growth.
With this kind of increase in the monetary base, there is little doubt that inflation would have reared its head and eat into real incomes. History suggests that it will take some time before it is curtailed.
Meantime, distorted asset valuations in the capital and housing markets that prevailed in the US have started to compress. Chewy- a pet food supply company in the US - that trades at a multiple in excess of 300 being just one example in a set too large to enumerate.
In this environment, the obvious question is whether stocks in the UAE will get affected. In an inflationary environment, companies - like toll bridges - act as a natural hedge against inflation. The infrastructure is built using ‘old money’ and does not require frequent replenishments of capital expenditure, with the result being that there is a greater ability to shield against inflationary forces.
Share price gains – and dividends
The same is true for power generation companies, although there is some capital expenditure that is required for an expanding population. It comes as no surprise then that companies like Salik have increased their share value by 45 per cent (not counting for dividends) since their IPO.
Empower increased by close to 20 per cent, and even DEWA returned shareholders 8 per cent in the form of cash dividends since it went public). In the FMCG sector, Americana jumped by 40 per cent since listing, again operating efficiently in an environment where same store sales benefit from rising prices, net of rising input costs.
These type of companies do not suffer from a compression in valuation multiples, as investors gravitate towards legacy assets with high ability to generate cash. Legacy assets extends to goodwill too, as the recent IPO success of Al Ansari indicates.
A multi-generation family business where the name is synonymous with bedrock safety not even found in banks amongst its loyal client base.
As we extend this line of thinking, natural resource companies also benefit as the underlying price of the commodity remains high, and the marginal cost of extraction is low. This is not to discount market signals that continues to favor technology - such as Bayanat and Presight that have performed to stellar effect.
Awaiting a turn in inflation
Rather, it is to state that valuations of companies that rely on growth will not expand as much during long periods of inflation. It remains to be seen how long the bout of inflation lasts. To get under control, the core issue of money supply must be addressed. Any reduction in such figures by definition necessitates a period of valuation contraction in companies not sufficiently hedged (lower ability to generate high levels of cash).
The interest in UAE and regional capital markets has coincided with a period of high inflation and companies on offer that protect against such corrosive forces, which has spawned an increased appetite by retail and institutional investors. Not all IPOs have performed well, and this may well be the case going forward for a few more.
At an aggregate level, both valuations and inflation hedges have played a critical factor that has driven up the level of demand from investors into well-run businesses that benefit with high inflation. It is imperative that inflation does not become entrenched, as its deleterious effects far outnumber any benefits.
However, we know that it takes an extraordinary amount of perseverance to rein in inflation expectations. The longer it lasts, the more vulnerable investors become to its corrosive effects.
The refuge that has been provided by the current wave of IPOs suggests a natural hiding place and a cornerstone for investors long used to not worrying about the higher costs of servicing debts. More are on the way.