Respond to inflation: rate hikes, electricity and infrastructure pricing
We have written about the positive aspects of the economy and have been impressed by the faster GDP growth led by the consumer and manufacturing sectors. Inflation is an area we continue to monitor. We believe that much of the increase is not as transient as the Federal Reserve believes – in particular, higher wages and rental costs. But of late, the commodity complex has also picked up steam, including copper, lumber, coal, natural gas and crude. In fact, the price of brent crude is up + 277% from its pandemic low and 40% above its 5-year average.
Companies most exposed to inflationary pressures such as rising labor costs and supply shortages are looking for new ways to protect their bottom line. Stocks whose valuations are tied to future earnings are reassessed to account for inflation and rising costs of capital. The market is turning to inflation hedging opportunities such as regular dividend income, cyclical stocks that take advantage of recovery demand, relatively undervalued companies, and those with pricing power.
While increasing the capacity of supply chain infrastructure requires a lot of time and capital to build (think ships and factories), increasing labor capacity involves more to encourage individuals to re-enter the labor market. There are currently 11 million vacancies. While many have left the workforce during COVID, we believe they will eventually return to work and lead to above-trend GDP growth for next year. This strong growth is one of the main reasons the Fed may start to slow down and has indicated that it will likely do so in November or December. If inflation remains higher than their typical target of 2% (and currently Core PCI exceeds 6%), that’s another reason to reduce monetary accommodation. Despite the headwinds of the supply challenge, the economic recovery is fundamentally strong and we expect nominal GDP growth in 2021 to remain above trend. For perspective, the last four quarters have seen an annualized CAGR of 17% of nominal GDP. This shows how strong the demand is in our economy.
Uneven impact of inflation on profitability
Operating margins across all industries have rebounded significantly from pandemic lows. Corporate profits for certain industries, driven by higher demand and improved efficiency, could have a long run for continued margin expansion.
In an inflationary environment, pricing power, secular growth, and spending discipline are all important to a company’s ability to grow its margins – in addition to the specific nature of the industries in which they operate and the exposures. at inherent costs. Some firms exhibit these characteristics better than others and it is worth assessing the rate at which they can grow their profits organically, at this stage of the business cycle and in conjunction with their own microenterprise cycle. Although all sectors have improved their EBIT margins since the pandemic lows, cyclicals and financials have seen larger increases than non-cyclicals and Tech +.1
Cyclical sectors like energy, although impacted by rising labor costs, benefit from the higher price of their goods / services, the discipline of investment spending and the increased profitability of existing infrastructure. Other cyclicals, including industrials, saw their margins jump about 300% from pandemic lows thanks to strong pricing power and operating leverage.2 Financials, benefiting from strong commercial and banking activity, as well as from now rising yields, experienced a disproportionate rebound in their margins. Each of these economically sensitive sectors maintains higher fixed overhead costs and excess liquidity. Companies that exercise spending discipline and those that have invested in improving operational efficiency during the pandemic may be able to achieve these high margins for longer.
Non-cyclical technology companies, whose wages represent a substantial component of their total costs, are at a greater disadvantage than most other industries when it comes to absorbing inflationary pressures on prices and increasing their margins. There are certainly secular growth opportunities and attractive addressable markets within tech and non-cyclical stocks – and we use a barbell approach to portfolio management – but in today’s environment, due diligence and conviction more high are put forward.
As we watch the margins grow, we have to recognize that the marginal profit of one is the marginal loss of another. This is why the pricing power is so important – the ability to absorb higher costs and thereby achieve higher unit revenues. The higher costs tend to fall on the non-cyclical, with limited pricing power, and on the consumer who must measure the marginal utility of the good against its additional cost (elasticity of demand).
Our friends at Credit Suisse created the what-if analysis below using an industrial company to represent cyclicals and a tech company to represent non-cyclical stocks, and the impact of 10% inflation on their profits.3 It provides a good summary of the above:
Hypothetical impact of 10% inflation on corporate profits
ASSUMPTION: Inflation jumps 10% across the economy, including wages, input costs and consumer prices.
Source: Credit Suisse
Investing in market rotation: our inclinations
Our portfolios have been oriented towards overweight cyclicals and secular growth technology companies throughout the period of economic recovery. We also maintained a bias in favor of quality balance sheets and excess free cash flow. As interest rates rise, the pace of yield curves increases and widening corporate debt spreads make it more costly for companies to raise new capital. Growth companies that rely on new capital to generate future profits, especially those with above-average valuations, are at greater downside risk in a market downturn and have less fuel for the market. growth. The economic recovery continues to be driven by consumer demand, the resumption of manufacturing and the decline in COVID cases. We believe the momentum favors undervalued cyclical companies that can grow organically in large, addressable markets with excess liquidity and pricing power.
Stéphanie Link: CNBC TV Program
Swiss credit. “Tech +” includes Internet retailing (excluding cyclicals) and the Internet parts of communications services.
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