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Why these sectors are better placed to weather the inflation headwind
With slowly moving into the distance, a myriad of negative pressures have created an inflationary outlook shaped by historically high levels of Government stimulus spending, rising interest rates and supply chain disruptions. The ongoing war in Ukraine has only exacerbated existing headwinds.
The rapid onset of inflation has caught many advisers off-guard. It means that advisers need to get a sense of how much companies can pass-on costs while maintaining margins. And going by the recent earnings season, the type of company that has pricing power has changed. The scale of inflationary pressures across fuel, commodities, food and distribution costs together with a tight labour market has crushed their ability to pass on higher prices. Margin deterioration and earnings downgrades are inevitable.
Chief Investment officer of Martin Currie Australia, Reece Birtles says, “As the inflation dynamic becomes more significant, the ability of companies to pass-through input cost increases to their customers is one of the most significant themes for investors to understand. Companies that have done well in this respect either have in-built inflation protections for their revenue streams and supply chains, or inflation leverage in their profit margins.”
Birtles says, in the past the type of company that was easily able to pass inflationary pressures to customers were your growth style companies. He says, “Until recently, service providers – typically growth-style stocks – were more likely to be able to increase prices. But now it is goods companies that appear to have a better ability to quickly pass-through their input cost increases in a transparent manner. Service companies are seeing higher costs in IT, compliance and wages, but with less price elasticity, meaning they cannot push prices up and still maintain sales.”
Martin Currie portfolio managers and analysts were able to meet with management teams of 100 companies to determine the inflationary impact and earnings outlook. Here are some examples of companies whose earning results showed strength, in this respect. They include:
Amcor and similar packaging companies have room to move without losing sales despite higher costs. Woolworths and Coles are also in a similar space. Consumer staples are essential, which means they have pricing power. Supermarkets are doing a great job of maintaining margins while passing-through any rising costs. However, some analysts are forecasting supermarket items to rise by 10 to 20 per cent as a direct knock-on effect of suppliers upping prices to cover higher fuel costs.
Birtles says “Accelerating inflation has been a positive for Scentre Group’s regional and super-regional shopping centres. They have high tenant occupancy and rental contracts with CPI-adjusted lease renewal mechanisms. Many infrastructure and utility companies also have CPI-linked contracts. Gas pipeline company APA Group’s operating expenses are a modest part of revenues, while revenue contracts are typically long-term take or pay with CPI-linkage mechanisms. As inflation increases, the dollar value of cash flow will increase.”
Banks too are relatively protected against margin pressure. As prices rise, households will come under pressure, but the banks are well provisioned. If anything, when interest rates rise, earnings rise.
The last reporting season was a good one, with a higher majority of companies upgrading earnings. Birtles says “In these upward revisions there is a skew to companies that are positively exposed to the reflation dynamic, rising interest rates and rising commodity prices. These stocks are generally found in the resources, financials and real assets sectors,” Birtles says.
On the flip side, there is usually a rotation out of growth and into value. On this occasion, there have been some massive price reversions. But in an inflationary environment, Australian and global value stocks are the place to be to benefit from higher inflation.
“Australia has very high-quality financials that will benefit from rising rates and resources companies that will benefit from the Russia disruption and the demand for net-zero transition. Now, more than ever is the time to allocate to value,” Birtles says.
