10 factors driving the risk of rising inflation
Without doubt one of the hottest topics on the minds of investors for 2021 is the risk of rising inflation and what this means for interest rates and global equity performance.
Typically, in the early stages of a cyclical recovery when inflation expectations start to rise, we see the market gravitate towards the perceived beneficiaries including commodity producers, banks and many cyclical industrials. It has been no different this time, with strong outperformance of many of the cyclical and rate sensitive parts of the market since the positive vaccine data started to emerge in early November 2020.
In addition, a range of factors including low/negative interest rates and government stimulus, have contributed to pockets of rampant speculative activity which has driven the share prices of many unprofitable growth and thematic stocks to arguably unsustainable levels.
While we haven’t been surprised to see this take place, we strongly believe that over the long-term share prices will be driven by underlying company fundamentals. As concerns over rising inflation and higher interest rates continue to build, we feel this could be a catalyst for market participants to return their focus to some of the key fundamentals which have arguably been ignored during the early stages of the cyclical recovery.
Below we take a closer look at some of the factors driving inflation and highlight some of the important company attributes that investors should be focused on in this environment.
10 FACTORS CONTRIBUTING TO RISING INFLATION
While predicting the outlook for inflation is a difficult task given there are many variables that can influence the outcome, we believe it is a key risk factor that investors should be monitoring closely as it can have a material influence on stock price and portfolio performance.
The top 10 factors contributing to the risk of rising inflation include:
Fiscal stimulus – The magnitude and speed of fiscal spending is a major factor that could drive a spike in inflation. In the US, the $5.2 trillion in COVID fiscal relief packages announced represent close to 25% of pre-COVID-19 gross domestic product (GDP), dwarfing the $831 million relief package during the Global Financial Crisis (GFC) in 2009, which represented just 5.8% of 2009 GDP.
Ongoing easy monetary policy – Low interest rates and bond purchase programs around the world continue to be inflationary for asset pricing levels and will likely contribute to broader inflation as the macro economic environment recovers.
Vaccine rollout – As the high efficacy vaccines get rolled out across the world during 2021, this should enable economies to re-open and support a strong rebound in economic growth.
Improving employment – In the US, the unemployment rate has already reduced to 6.2% after peaking at 14.8% in April 2020 but still remains well above the pre-pandemic level of 3.5%. A normalising job market could put upwards pressure on wages and improve the financial position of many households, leading to increased consumer spending.
Consumer confidence – Consumer confidence likely improves moving forward due to the improving job market, impact of stimulus programs and benefit from accumulated savings through the pandemic.
Political environment – Moving from a more pro-corporate environment (under Trump) to more pro-labour (under Biden). In particular, the potential for a minimum wage increase in the US could be a big inflationary driver.
Unwind of globalisation benefits – We may see an unwind of some of the benefits of manufacturing in low cost labour countries as companies look to shore up their local supply chains and reduce the risk of tariffs.
Increased ESG focus – The increasing focus on environmental and social responsibility-related factors could drive increased costs in certain areas, including wages, employee safety, supply chain and sourcing costs, and costs to meet environmental targets.
Supply and logistic bottlenecks – We are increasingly hearing from many corporates about supply chain issues, logistic bottlenecks and delays in sourcing parts and finished products. As an example, the dry van rate per mile (proxy used to gauge spot logistic costs), is up 45% since the start of 2020 and up 90% since the March 2020 trough.
Input cost inflation – We are seeing widespread inflation in input costs from a sharp increase in various soft and hard commodity prices. The S&P GSCI index, which tracks a basket of over 20 soft and hard commodities including oil, gas, gold, copper, aluminium, wheat, corn, cotton, cocoa, cattle etc., is up 12% since the start of 2020 and up over 100% from the March 2020 trough (now back close to five-year peak levels).
The combination of factors outlined above certainly mean there is a material risk of inflation spiking in the near term, which will likely lead to increased fears around rising interest rates. However, there is still uncertainty around how sustainable any increase in inflation will be and what this means for interest rates.
From a long-term perspective, there are still many structural factors that could keep a lid on inflation concerns, including ongoing efficiencies from automation, technology, globalisation, and low-cost sourcing, so only time will tell whether inflation fears will be long lasting.
IMPORTANT COMPANY ATTRIBUTES IN THIS ENVIRONMENT
If fears over rising inflation and higher interest rates continue to grow, we believe this could be a catalyst for market participants to return their focus to some of the key fundamentals which have arguably been ignored during the early stages of the cyclical recovery.
In our view, some of the most important company attributes for investors to consider during periods of rising inflation and higher interest rates include:
Pricing power – In an inflationary environment one of the most important attributes for a company to possess is good pricing power (i.e. the ability to pass on rising costs without materially impacting volumes). Companies with sustainable competitive advantages typically have the best pricing power.
Strong balance sheets – During periods of low/negative interest rates and ‘easy money’, balance sheet strength is often ignored. If we move into a rising rate environment then we will likely see much greater focus placed on balance sheet strength.
Valuation risk – In a rising rate environment, one of the single biggest risks to equities is ‘valuation risk’, especially the parts of the market with more extreme valuations or valuations based mostly on long dated cash flows (i.e. unprofitable growth companies) which would likely be hit harder due to the influence that a rising discount rate has in lowering the present value of forecast future cash flows. Valuation discipline is therefore extremely important in this environment.
In summary, the threat of rising inflation and higher interest rates is a key risk factor that we believe all investors should be considering. As the risk increases, investors are likely to refocus more on company fundamentals and valuations.
Looking forward, we believe investors who adopt an investment strategy focused on investing in quality companies that possess good pricing power, strong balance sheets, highly-visible cashflows, and are trading at a reasonable price, will be well placed to outperform.
Joel Connell is senior global equities analyst at Bell Asset Management.
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