As the COVID-19 pandemic begins receding in the U.S. and the economy begins to reopen, shortages of goods and high government spending have inflation on the rise in some areas. Gradual price increases over time are actually a good thing. It's indicative of a healthy economy. However, after more than a decade of inflation running too cold (less than 2% a year), worry is mounting that the rate will jump to unhealthy levels as consumer and business spending activity picks up the pace this year.
For the record, I think this will be a transitory problem and high inflation will moderate in a year or two as effects of the pandemic ease. Nevertheless, it never hurts to have your portfolio ready for all sorts of conditions. That's why I've been loading up on PayPal Holdings (PYPL 3.54%), Square (SQ 2.54%), SVB Financial Group (SIVB.Q 0.50%), SoFi (Social Capital Hedosophia Holdings V (IPOE)), and Upstart Holdings (UPST 20.96%).
Higher traffic passing through the tollbooth
Digital payments could be a top beneficiary from inflationary forces. Besides a general secular trend favoring digital and online transactions over cash, higher prices for consumers and businesses trickle down to higher revenue and profitability for these businesses. Because digital payment platforms act like a tollbooth that charges a fee for processing transactions on their network, higher volume equates to higher tolls for these companies. PayPal and Square rank as my top two picks in this arena.
For PayPal, a pickup in consumer activity means a continuation of the fantastic growth rates it posted in 2020. In fact, management provided an outlook for total payment volume (TPV) to increase about 30% this year on top of the 31% growth rate from last year. This should work out to revenue growth of about 20%, and as PayPal already has its core network built out, most of these gains will head directly to the bottom line. For reference, PayPal's free cash flow increased 48% last year to $4.99 billion on revenue growth of 22%. Put another way, inflation is little worry to PayPal at this juncture. Expect another year of rapid expansion.
While PayPal has gotten a boost from a rapid rise in online spending, Square's core business got hit hard in 2020 because it relies heavily on in-person spending at small and midsize businesses. But this core segment is starting to rally. Transaction-based revenue was up 27% year over year in Q1 and is about to start lapping depressed quarterly financials from last spring at the onset of the pandemic. Its peer-to-peer money movement service Cash App was a particular standout during the last quarterly update. Cash App revenue (excluding Bitcoin) was up 139% from a year ago in Q1 to $529 million.
Speaking of Bitcoin and cryptocurrencies in general, PayPal and Square both allow crypto trading, through Venmo and Cash App, respectively. If cryptocurrencies continue to gain traction as a method of payment, both could end up being top apps facilitating their movement. After all, cryptocurrencies were designed to be a semi-decentralized payments network that cuts out intermediaries, like banks, to reduce business and consumer transaction fees. Plus, some investors are beginning to view Bitcoin as a type of "digital gold," since there are a finite number of Bitcoins that can ever exist, and it's being used as a hedge against inflation in some portfolios. Square has a sizable Bitcoin horde on its balance sheet and will benefit in a big way if Bitcoin's price rises over time -- either from inflation fears or as a rising form of online payment.
Bet on better banking and lending
When inflation picks up pace, bank stocks are a top pick. Case in point: After a rough 2020, the Dow Jones U.S. Bank Index's total return is up nearly 35% this year at Monday's closing price. SVB Financial Group and SoFi -- soon to go public through special-purpose acquisition company Social Capital Hedosophia Holdings V -- are my two go-to bank picks.
Why bank stocks? As inflation rises, along with expectations for inflation -- as it usually does during periods of economic recovery -- interest rates tend to follow suit. This situation can lead to a widening in the difference between short-term and long-term interest rates. A steepening yield curve is fantastic news for lenders, as it means a growing margin between what it doles out for cash on deposit and what it lends to borrowers -- i.e., short-term versus long-term rates. SVB Financial, better known as the parent of Silicon Valley Bank, lends specifically to tech and healthcare start-ups and venture capital. It has a growing client base and lots of equity in fast-growing tech businesses, creating a dual tailwind for this traditional bank. Interest income rose 11.5% in Q1, contributing to a net income increase of 37% year over year in the first quarter.
SoFi is a nontraditional digital bank, and as a lender -- it got its start offering personal loans -- it, too, could benefit if inflation helps improve interest rates in its favor. But this is also a growth story, and SoFi is in the early chapters of its journey. Total members soared 121% from a year ago at the end of March 2021 to 3.19 million. Adjusted net revenue also trounced the company's own guidance for as much as $195 million in Q1, coming in instead at $216 million, up 151% from a year ago. Growth like that will easily put inflation worries to rest.
Then there's Upstart, which itself isn't a bank. Though it does dole out a few loans here and there directly to borrowers, the bulk of its revenue comes from partner banks and other lenders subscribing to its artificial intelligence service. Upstart's platform automates the lending process, and its non-traditional data collection helps banks issue more loans at a lower loss rate. It's a win-win situation as banks look for new ways to attract customers and increase profits. For now, Upstart helps with personal and auto loans but has its eye on other areas of the consumer credit industry. If inflation rises at a moderate pace, this tech firm and its banking partners will be big winners. Upstart is forecasting revenue growth of about 158% this year.
Rising prices on goods and services isn't exactly palatable when it comes time to pay the bills, but inflation isn't a death knell for investing. On the contrary, moderate inflation is indicative of a healthy economy and could provide a tailwind for digital payments and banking stocks this year.