Inflation has been in hibernation for decades, but alarms are now ringing for investors
Thursday 29 Apr 2021 Author: Steven Frazer

Investors spent 2020 worrying about Covid-19 but as vaccines rollout and economies begin to gradually reopen, equity markets are getting increasingly jumpy about a new threat - inflation.

Investors should not treat these warnings lightly. The most obvious response to rising inflation for central banks (the Bank of England  in our case) is to reverse  ‘lower for longer’ interest rate trends, making borrowing more expensive for businesses, increasing mortgage payments and leaving us all with less to spend, save and invest.

These are big picture issues that may leave individual investors feeling helpless but you can prep your portfolios to give yourself a level of protection. We also suggest five stocks with sufficient growth levers, pricing power and   inflation protection to do well even if prices start to rise sharply.

IS RISING INFLATION INEVITABLE?

In simple terms, the market is worried that trillions of dollars of government-backed stimulus, record low interest rates and millions of consumers with surplus cash eager to get out and about again, could unleash a wall of spending that forces prices up, and frees the inflation beast from three decades of hibernation.

Inflation has been out of mind for so long that it is easy to forget the savage economic hardships of say, the 1970s, 1980s and early 1990s in the UK. In the 1980s, for example, double-digit inflation was only cut by a savage recession during which unemployment rose to its highest level since the Great Depression.

‘Moderate inflation is generally good for equities because it tends to be associated with positive economic growth, rising profits, and stock price gains,’ says Schroders market strategist Sean Markowicz.

But things can quickly turn ugly for stock market investors if the economy overheats and inflation runs wild. The Bank of England base rate hit 14% in 1990, making life more expensive for consumers and businesses, and subduing company profits and dividends.

‘Months of rising inflation are associated with lower relative real equity returns and one needs to understand that inflation raises the cost of capital and introduces volatility, making decision making more difficult for companies,’ said Peter Garnry, head of equity strategy at Saxo Bank.

‘The green transformation and ESG trend (environmental, social, governance) will also add to inflationary pressures as it’s more costly to expand both non-renewable energy sources and mining capacity in the much-needed metals for the electrification of society.’

WHERE WE STAND NOW

Inflation in the UK is measured by the consumer prices index, or CPI, a theoretical basket of readily available goods and services, such as food, clothing, rent, transport, healthcare and much else. If homeowner mortgage costs are included the index is called the CPIH (H for housing).

Most recent CPI data showed price inflation rose 0.7% in March from a three-month low of 0.4% in February. The consensus expectation had been for inflation to rise to 0.8%, according to Howard Archer, chief economic advisor to the EY ITEM Club.

What's in the CPI basket?

In March the consumer price index basket of goods was changed, including things like electric and hybrid cars, hand hygiene gel, men’s loungewear bottoms and smartwatches. Staff restaurant sandwiches and gold chains were among the items removed.

‘Inflation was primarily lifted in March by higher fuel prices,’ Archer said. Oil prices had fallen significantly early on in 2020 and the latest year-on-year increase was magnified by oil prices hitting a 13-month high in March. Small increases were seen in clothing prices and some household goods, versus falls in food prices.

‘Inflation also continued to be held down by the temporary VAT cut from 20% to 5% introduced last July for the hospitality sector, hotel and holiday accommodation and admission to certain attractions,’ said Archer.

Rather than something to worry about, March data is a source of optimism, according to Ian Warwick, managing partner at Deepbridge Capital. ‘The inflation data is further evidence that the economy is moving in the right direction,’ he said, and CPI is still way below target. This is not the kind of embedded, long-term inflation that will cause sleepless nights for anyone at the Bank of England.

HOW BIG A THREAT IS RISING INFLATION?

Market strategists at broker Canaccord Genuity, however, say that the ‘starting point matters enormously.’ This time last year the pandemic caused inflation to collapse all over the world, setting a very low comparison threshold for this year’s prices.

‘As a result of lockdowns, partial re-openings and supply chain issues, many bottlenecks have emerged which will inevitably cause certain prices to rise,’ the Canaccord team said. ‘It doesn’t take much more than that for the market to expect soaring inflation, and hence the prospect of the US Federal Reserve stemming it by raising interest rates.’

‘Rising interest rates are likely to create a downward adjustment of equity valuations in the most speculative growth segments as we observed in late February and early March, and as vaccinations are rolled out and the US economy re-opens, it will be in a situation of very high stimulus and no output gap,’ says Saxo’s Garnry.

Iain Pyle, investment director at Shires Income Trust (SHRS), remains relaxed, however. ‘At the levels we are looking at it is of limited threat,’ he believes, pointing out US inflation projections of 2.5% five years from now.

‘This kind of inflation is relatively healthy for an economy and it would need to be higher before central banks stepped in to take action and slow economic growth.’ The Fed has already explicitly stated they will let the economy ‘run hot’ for a while with the view inflation will be transitory, the manager says.

WHAT ABOUT THE US

While the Fed has steadfastly confirmed that it will not raise interest rates for years (2023 at the earliest), it has not ruled out tapering its asset purchases.

‘Given that government bond yields have soared this year, from 0.9% to nearly 1.7% for  the US 10-year bond and from 0.19% to 0.82% for the UK 10-year gilt, markets are concerned that this could spark another ‘taper tantrum’ as bond yields soar further and trigger a bigger correction in equities,’ says Canaccord’s analysts.

The Fed’s inflation gauge - the Core PCE (Personal Consumption Expenditures) Price  Index - has been consistently below the Fed’s target of 2% during the whole of the last economic cycle, according to Canaccord, with a couple of brief exceptions. Going forward, inflation targets will be a more fluid range based on rolling averages over longer periods rather than the absolute numbers of the past.

‘Given that Core PCE has lagged its 2% target for 12 years, the Fed is saying it would be willing to wait for a few years with inflation above the 2% target before stepping on the brakes,’ says Canaccord, but markets are unconvinced and look for signs that a spike in prices will cause an interest rate rise soon.

‘It is inevitable that we will see some nosebleed inflation readings in the next few months, but unless they are sustained for the whole year at least, it is unrealistic to expect that the Fed’s interest rate policy will be reversed so soon after announcing it,’ says the Canaccord team, especially given that the last Fed policy lasted 40 years.

The question is, will markets pay attention to what the Fed says and does, or will they keep expecting the worst, which will mean more volatility for share prices. ‘Eventually, markets will get the message, but there could be some moments of extreme concern caused by inflation tantrums,’ believe Canaccord’s equity strategists.

INFLATION EQUITY HEDGE

Inflation-linked bonds can offer better protection from increased inflation, although the returns on offer may be pretty dismal. Gold and certain commodities, copper say, are also generally geared to higher prices. These investments can be woven into a balanced investment portfolio meaning an inflation spike need not be wealth-destroying for investors.

‘For equities, the impact is modest on overall valuation as they are a natural hedge to inflation with rising prices leading to higher earnings and cash flow,’ says Shires’ Iain Pyle. On the other hand, this may be offset by a contraction in  profit margins given an increase in companies’ input costs.

In practice, the impact of inflation on earnings will vary by economic sector and its ability to pass on higher input costs to end consumers. As long as input costs do not increase at the same rate as revenue the rise in profit margins should translate into greater nominal earnings.

‘The problem is that the market will often discount those future cash flows at a higher interest rate when inflation rises, to compensate for the fact they are worth less in today’s money,’ says Schroders’ Sean Markowicz. All else being equal, the higher the level of inflation, the greater the discount rate applied to earnings and therefore the lower the price to earnings ratio investors are likely to be prepared to pay.

WHAT INVESTORS CAN DO

‘Our research has found that equities outperformed inflation 90% of the time when inflation has been low, below 3% on average, and rising,’ says Schroders’ Markowicz. This is where we are today. But when inflation was high (above 3% on average) and rising, ‘equities fared no better than a coin toss,’ the strategist says.

This means that investors should at least consider their options. ‘Even if you believe the argument for balanced inflation at the moment, we are coming out of an extended period when inflation was not even discussed, bond yields were in terminal decline and growth outperformed value equities for a long period of time, causing some very stretched valuations,’ says Shires’ Iain Pyle.

Even just normalising those forces, as we have seen in the last six months, creates a rotation in the market and investors can’t just assume growth equities will keep having their valuation supported by falling yields. ‘In my view there is a need for more balanced portfolios, with many investors still underweight areas like energy and financials that would benefit from higher inflation,’ Pyle says.

‘Moderating those underweight positions seems sensible to me.’

There is also a greater need for active management with genuine fundamental analysis to find those companies that have pricing power and can benefit from this cycle, such as our five company picks.

SECTORS WITH PEDIGREE

Pyle says that sectors which to do better in rising inflationary environments tend be those that are more economically sensitive and cyclical, partly because it correlates with economic growth. He flags oil and gas, mining, autos, chemicals and financials. Staples, healthcare and utilities tend to lag, he says.

Schroders’ Markowicz agrees. His research shows that energy firms, including oil and gas companies, beat inflation 71% of the time and delivered an annual real return of 9% per year    on average. This is a fairly intuitive result because the revenues of energy stocks are naturally tied to energy prices, a key component of inflation indices.

‘By definition, energy stocks will perform well when inflation rises,’ says Markowicz.

Equity REITs (real estate investment trusts) may also provide protection, according to the Schroders man. They outperformed inflation 67% of the time and posted an average real return of 4.7%. ‘This makes sense too. Equity REITs own real estate assets and provide a partial inflation hedge via the pass-through of price increases in rental contracts and property prices,’ Markowicz says.

The opposite is true, in theory, of the promised future growth in profits for technology stocks. The bulk of their cash flows are expected to arrive in the distant future, which will be worth less in today’s money when inflation increases.

Financials, on the other hand, perform comparatively better, according to Schroders research, as their cash flows tend to be concentrated in the shorter term. That said. high inflation can still be harmful, especially for banks, because it erodes the present value of existing loans that will be paid back in the future.

‘I think the current trends for rising inflation and higher yields are more relevant for short-term investors,’ says Shires’ manager Iain Pyle, but everyone should be aware of it. ‘The long-term is made up of a number of short-terms and after a long period of deflation and a concentration of investment into growth equities, even a partial unwind of that trend could be meaningful.’


Five inflation-busting picks

Convatec (CTEC) 205.3p

ConvaTec (CTEC) is a medical products group focused on the treatment and management of chronic conditions. Its key franchises are advanced wound care, infusion care, continence and ostomy care.

The firm’s products will always command a premium price due to the sensitive nature of demand and the growing spend on healthcare by governments both in developed and developing markets.

While the UK was in lockdown and the health service managed the virus, elective surgeries were naturally put on hold, impacting Convatec’s sales. However, other parts of the business saw incremental demand and the firm still grew its revenues by 4% last year.

With the vaccine successfully rolled out in the UK and restrictions lifted, demand is expected to increase. Meanwhile, the firm has stepped up its spending on research and development and its investment in key markets such as the US and China, laying the foundations for future growth.

Estee Lauder $314

We believe it is worth buying quality skin care, makeup and fragrances maker Estee Lauder, whose wide economic moat and scarcity value are reflected in an attractive long-term share price chart.

Blessed with a valuable portfolio of global prestige beauty brands which confer pricing power upon the business, Estee Lauder should prove a reliable inflation hedge given its capacity to pass on input costs to customers prepared to pay up to look glamorous and generate robust margins and copious cash flow as a result.

Controlled by the Lauder family, Estee Lauder’s prized portfolio of brands includes Estee Lauder, Aramis, Clinique and Tommy Hilfiger, not to mention La Mer, Jo Malone London, Michael Kors, DKNY and TOM FORD BEAUTY.

The $112.4 billion cap’s attractions also include a thriving online business and good scope for growth in emerging markets. Having returned to growth in the second quarter to December despite retail store closures, sales growth forecasts could prove conservative as department stores, specialty beauty outlets and travel retail locations reopen and the world returns to socialising and travelling.

Games Workshop (GAW) £107.40

Fantasy miniatures and table-top war games manufacturer Games Workshop (GAW) has a loyal and still growing fan base.

This has been built through the company’s single-minded dedication to creating the highest quality figures and investing in the best manufacturing and tooling equipment, which protects the company from inferior imitators.

Its retail shops provide enthusiasts with a space to share their passion while thousands of hours of online content support the brand value.

This interaction is designed to create a feeling of being part of a community and strengthens loyalty while increasing the likelihood of repeat sales.

In addition, there is still a lot of potential to exploit the value of the brand and intellectual property which the company has been developing in recent years as seen by growing royalty revenues.

These economic advantages built by the company suggests it has strong pricing power.

Impact Healthcare (IHR) 114.8p

Shares in care home investor Impact    Healthcare (IHR) trade at a more modest premium to net asset value than peer Target Healthcare (THRL) (6.3% against 11.1%) and  offer a generous 5.6% yield backed by 100% inflation-linked leases.

The company was clearly impacted by the Covid-19 pandemic given the disproportionate impact of the virus on its tenants – the care home operators – and the people living in care homes too.

However, having paused M&A in 2020 due to the disruption, the REIT recently returned to the acquisition trail. It has bought an 86-bed care home in Lowestoft, Suffolk via a sale and leaseback transaction with the current owner and operator, Carlton Hall, and entered into a pre-let forward funding arrangement with Carlton Hall for a new 80-bed care home in Norwich.

Numis commented that ‘the introduction of Carlton Hall as a tenant adds ‘further diversification to the tenant roster’.

Polymetal International (POLY) £16.03

Because it is possibly the best long-term store of value, gold has always been considered an inflation hedge, and should be part of anyone’s portfolio if they’re looking to protect against inflation.

But rather than hold the commodity itself, for real inflation-busting returns pick a gold miner. Miners are leveraged plays on the commodities they produce, and as gold rallied over 20% last year some miners saw their shares double.

Choosing the right miner is important and we like Polymetal International (POLY). It’s expensive on a price-to-book value of 5.2 times, but that didn’t stop the shares rallying hard last year as gold rose and reflects the fact it’s arguably the most operationally sound London-listed miner, with none of the production hiccups that affected its peers.

It also has industry leading quality metrics with a 38% return on capital, 55% return on equity and profit margins of over 50% as it successfully capitalised on the soaring gold price, as well as a forecast 7.5% dividend yield.

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