Investors should pay attention to the fact that companies in different industries are affected differently by inflation.
Until recently, it has been very quiet on the topic of inflation in the developed world for several decades. When it became the subject of attention, it was because there were fears of a slide into a disinflationary environment or even deflation. Important drivers of persistently low inflation in recent years have been:
The current December inflation readings of +6.8% in the U.S. and +4.9% in the euro area were well above the modest averages of recent years; in the U.S., they were even the highest since 1982 (see chart 1). Even Switzerland recorded higher inflation by its standards at +1.5%. This deserves some attention.
The Corona pandemic set several stones in motion that have significantly upset the balance of power between supply and demand. The causes of the newly burgeoning inflation lie in a complex interplay of several factors:
As a result of the gap between supply and demand, prices for scarce goods - e.g. microchips - rose significantly. Transportation costs rose to unprecedented levels, and labor costs for urgently needed truck drivers skyrocketed. As a result of the stalled production of new cars, car rental companies such as Hertz and Avis in the USA, for example, were unable to renew their fleets, so they used existing vehicles for longer. This in turn caused bottlenecks on the used car market, whereupon the prices for used vehicles shot up.
The stock market feels most comfortable with moderate, stable inflation. Historically, the highest valuation multiples are paid in such an environment because the reliability of earnings estimates is high and uncertainty is correspondingly low. In a rising inflation environment, three key factors have a negative impact on the stock market, with a time lag:
Initially, when inflation picks up, stocks of companies in the consumer sector often carry increased risks. In the consumer staples, for example food producers, higher purchasing costs for cocoa, cereals and packaging materials have an impact. In the consumer discretionary sector, the traditional, labor-intensive retail trade, hotels and restaurants, and in the industrial sector, e.g. logistics, are affected to an above-average extent by rising labor costs. Within these sectors, pricing power and strong branding are therefore very important in order to be able to implement price increases without compromising sales. Investors should therefore focus on companies with strong pricing power, which generate high revenues per employee, offer high added value for their customers and have a strong brand. Relatively immune to inflation are technology companies, luxury goods manufacturers, and oil and energy suppliers.
However, as soon as the central banks tighten the monetary screws and interest rates rise, the situation is slightly different. Companies from so-called "mature" sectors then become less attractive. Such companies often have below-average growth rates and above-average dividend payments and are therefore regarded as "bond substitutes" respectively “bond proxies”. For such shares, interest rate increases mean that the "excess yield" of the dividend relative to interest rates declines. Among other things, stocks from the utilities, telecommunications and, in some cases, consumer staples sectors are affected. Furthermore, highly valued growth companies often also come under pressure because the present value of their future earnings declines with a higher discount factor, a reverse "compound interest" effect, so to speak.
However, there are also sectors that benefit from rising interest rates. These include in particular financial stocks such as banks and insurance companies, but also companies with constant dividend growth, which can at least defend the "dividend advantage" over interest rates or possibly even continuously improve it.
In view of the current inflation trend, has the time come for equity investors to make massive adjustments to their sector weightings? We believe that now is not the time to take extreme positions. A moderate overweight in financials seems appropriate, while in the other sectors, attention should be paid to the quality characteristics of a strong brand, high added value and correspondingly high pricing power. Although overall inflationary pressures are likely to persist for some time, we believe that the highest rates of price increases are in sight, after which a moderate easing should set in. The reasons for this are as follows:
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