The recent rally in the S&P 500 has led many to believe that inflation has been defeated and that interest rate cuts are imminent. However, what the market seems to be overlooking is the risk of an economic slowdown. In reality, deflation could pose a much greater threat to equities.

The signs of a faltering economy are evident, with US inflation slowing to 2.5 per cent in August. The price of oil has dropped by 10 per cent in the past month, the US two-year treasury yield is down 40 basis points, and job openings in the US have reached their lowest levels since 2020. While the debate continues on whether the US will enter a recession, it is clear that the growth rate of the economy is slowing down, which could have severe implications for companies.

Inflation typically boosts company earnings, as rising prices lead to increased revenue while fixed costs remain stable. This dynamic, known as operating leverage, can significantly improve operating margins for companies. However, if the economy enters a period of deflation, where prices and revenues start to decline, companies with high debt and fixed costs could face financial challenges.

Renowned risk analyst Nassim Nicholas Taleb advocates for building antifragile businesses that are resilient to economic downturns. By avoiding excessive debt and fixed costs, companies can better navigate uncertain economic conditions. Taleb emphasizes the importance of redundancy in business operations, as it allows companies to thrive in times of recession by taking advantage of opportunities that arise when asset prices fall.

A prime example of this strategy is Disney’s acquisition of Marvel Entertainment during the global economic slowdown in 2009. Disney’s strong balance sheet enabled it to capitalize on Marvel’s financial vulnerability, leading to a highly profitable investment over the years. The acquisition highlighted the significance of access to capital in times of economic uncertainty, as companies with financial strength have the flexibility to make strategic moves when others are struggling.

In conclusion, the ability to adapt to changing economic conditions is crucial for businesses to thrive in a volatile market. By focusing on building resilience and maintaining financial flexibility, companies can position themselves to weather economic downturns and capitalize on opportunities that arise during uncertain times.