Are we close to peak inflation? Possibly, but one investment fund believes the theme will be at the forefront of markets for longer than you might think.

Lazard Thematic Inflation Opportunities Fund (BLNKWV8) invests in companies which display the type of characteristics you’d want when the cost of living is high. These include the ability to push up prices without hurting demand and to protect or even grow profit margins while many other companies are seeing a decline in earnings.

SIGNS OF DEFLATION

Many of the factors which drove inflation are now in reverse. Oil prices have recently eased back, other commodities like copper have declined in value and shipping rates are falling. The US latest inflation figures were even lower than expected.

Despite this situation, there are several reasons why investors might want to look at the Lazard fund. It’s all down to how central banks might respond to a recession caused by aggressively raising interest rates to combat inflation.

‘The base effects of moving into next year means you can see signs of inflation rolling over,’ says portfolio manager Steve Wreford. ‘For this side of the Atlantic, inflation has been caused by energy and food prices, and that’s what has led to this cost-of-living crisis, along with damaged currencies. If commodity prices remain flat going into next year, then inflation would drop down.

‘In the US, the drivers of inflation are probably stickier because they are related to wages which are growing at about 5% to 6% and shelter costs such as rent.’

INFLATION IS STILL HIGH

Between 2012 and 2021, the average rate of US consumer price inflation was 2.8%, according to data from the Federal Reserve Bank of Minneapolis. The annual rate in this period was as low as 0.1% in 2015.

Inflation noticeably started to pick up in 2021 with a 4.7% increase, and it soared in 2022.

With inflation currently at 7.7% in the US and 11.1% in the UK, there has been a real shock to the system. Central banks are racing to lift interest rates to fight inflation. The risk is the pace and scale of interest rate hikes cause a big slump in consumer spending and business investment which in turn causes a recession.

‘Policymakers will panic, start the printing presses again and inflation returns,’ suggests the portfolio manager. ‘The lurch from inflation to recession and back to inflation again is what happened in the 1970s. The average level of inflation from 1968 to 1982 in the US was 7.3%, but CPI spanned from 2% to 15%, and that’s the environment we envisage.’

The traditional playbook for investors during times of rising inflation is to put money into real assets such as property, commodities and infrastructure. Equities can be choppy when inflation is moving higher, yet Wreford believes there is a subset of the stock market that can ‘do well, prosper and benefit’ when the cost of living is rising.

Some equities are obvious ones to own, others are underappreciated by the market which gives stock pickers like Wreford an opportunity to buy certain companies at undemanding valuations.

Lazard Thematic Inflation Opportunities Fund launched in September 2021, with a version made available to retail investors in June 2022, so it is too early to judge its performance. It has a 0.91% ongoing charge.

Oil producers account for four of the top 10 holdings and nearly 10% of the Lazard fund’s total investments, led by Shell (SHEL) and BP (BP.). Industrials feature heavily with approximately 18% of the fund in this sector including mining equipment group Caterpillar (CAT:NYSE).

DEERE SHARES ARE TRADING AT A RECORD HIGH

The biggest portfolio position is agricultural equipment giant Deere & Co (DE:NYSE), whose fourth quarter results on 23 November beat market forecasts at the sales, operating income, earnings per share and operating cash flow lines. For full-year 2022, it saw a 20% increase in net income to $7.1 billion. Its end markets are doing well, leading to solid demand for kit from dealers and end-users.

‘Deere sits under the “industrial pass-through” type of investment opportunity for our fund. These types of companies typically sell to businesses, and they have a secret – embedded within their business model is the ability to contractually pass through some form of their input cost.

‘Not all companies can pass through input costs – in the last 12 months, many companies have seen huge margin compression. But there is set of companies whose margins have gone up or stayed flat, and those are the ones you want to own in an inflationary environment,’ says Wreford.

FEASTING ON BURGERS

McDonald’s (MCD:NYSE) is in the Lazard fund and benefits from the ability to push up prices and not worry about a big drop-off in demand. The real attraction is being a franchise owner.

The franchisee must deal with rising costs of labour, food and energy, so the natural move is to charge more for burgers, which is exactly what we’ve seen with McDonald’s restaurants. Yet the McDonald’s on the stock market is the company that owns the master franchise, so it is collecting a fee on all product sales, typically between 12% and 21% of revenue. Therefore, the more the restaurant charges for items, the more the master franchise owner will earn.

The other thing to consider is that McDonald’s is beneficiary of inflation because the rising cost of living drives more traffic to its restaurants. The Lazard portfolio manager says the people hurt most by inflation tend to be low-income workers. When prices go up, people trade down from sit-down restaurants to fast-food joints, so visits to McDonald’s go up and not down.

‘(The McDonald’s franchise owner on the stock market) is clipping the coupon from the rising price of a Big Mac. That is an attractive business model and means its profits go up.’

‘OFF THE BEATEN PATH’ STOCKS

Elsewhere in the portfolio you’ll find a few companies in the building materials space including Vulcan Materials (VMC:NYSE) and Martin Marietta Materials (MLM:NYSE) which own quarries and dig out what’s needed to build highways and infrastructure projects.

‘These stocks are off the beaten path for most investors, but they are exactly the sort of thing you want to own in an inflationary environment because in big motorway projects, the costs are passed through, and there aren’t that many of these companies in the developed world.’

Wreford explains that one of the big costs for infrastructure projects is transportation of materials, hence why the aggregates industry tends operate on a local scale with limited competition. ‘If there is a tidal wave of money being printed by the government you want to be in the way of it, and these materials companies are beneficiaries of big infrastructure spending.’

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