Interactive Investor

Stockwatch: an inflation survival plan for investors

The rising cost of goods and services has to be watched like a hawk, our columnist argues.

21st May 2021 13:06

Edmond Jackson from interactive investor

The rising cost of goods and services has to be watched like a hawk, our columnist argues.

We are in the grip of a remarkable economic turnaround – from doom to boom. 

A year ago, we were looking at an unprecedented slump likely to persist, given vaccines apparently would not be rolled out until 2022 – if they worked much at all.  

Now, global GDP is predicted to rise above its pre-Covid-19 path from the third quarter of 2021 and reach 6.5% annualised. That would represent the sharpest-ever cyclical rebound, although remember that the 2020 comparator was weak. 

Recovery in personal incomes means consumption growth will be sustained, hence a consensus for global investment to reach 120% of pre-Covid levels as firms boost capital expenditure. 

Is the US a special case, or portent? 

It is hardly surprising that high valuations on US stocks have foundered on inflation fears. While 4% inflation there seems more significant than a doubling here to 1.5% in April, be aware that the US stock market typically leads others.  

Yesterday’s good US jobs data offered stocks a respite, but affirms the essential dilemma: a sharply recovering economy, conflating with high disposable income (helped by government handouts) and supply shortages’ forcing up prices. 

UK inflation is sure to go higher with energy price hikes due, which in turn will put up many businesses’ costs. Some economists say wage bargaining is not powerful like it used to be, and wage inflation is the critical factor. Time will tell. 

Bull versus bear scenarios on equities  

The bull case on equities is inflation being “as expected” while Covid vaccinations help economies open up. Shortages and bottlenecks will be temporary, which is why the US Federal Reserve maintains a 2% inflation target for later this year. Its asset purchase programme will not even begin to taper until April 2022 and you “don’t fight the Fed”.  

Bears argue the authorities have already lost control. They think inflation will trend higher and then stick, giving them a dilemma since they cannot raise interest rates materially without causing a debt bust. And never mind what central bankers say: if inflation is getting serious, markets will price for higher interest rates ahead anyway.  

Since US growth stocks have enjoyed a stupendous run during past years of ultra-low interest rates, they are especially exposed if the financial environment is changing – it would appear, from a low inflation/growth era since 2008, to high inflation/growth as governments pursue a reflationary agenda.  

Inflation’s uptrend in economic data and firms reporting  

London-listed McBride (LSE:MCB), a provider of household and personal care products, is pertinent. Last February, it noted rising input costs albeit in line with expectations. But by early May: “In recent weeks there has been further rapid, significant and sustained price escalation for many of our raw materials, particularly core chemicals and plastics. We will see further double-digit increases on average across these materials and packaging items by June 2021 – more than double the rates of increase expected in mid-March 2021. Additionally, we do not see these prices returning to more normalised levels in the near future.” 

If this is at all a general trend then it is going to hurt corporate margins. 

Yesterday, Kingfisher (LSE:KGF) cited suppliers struggling to keep up, the situation made worse by raw material shortages. It said: “We expect these challenges to continue for at least the next six months...we are also seeing inflation pressure from certain raw materials and shipping container costs.” 

Wider consumer goods’ price inflation looks inevitable given China - “the workshop of the world” – saw its producer price index rise 6.8% year-on-year in April, the fastest for more than three years after being negative for nearly all of last year. In due course this is going to find its way into Western consumer price indices. 

In the US, last Tuesday, a spot (i.e. current) commodities price index reached its highest level since 2011. Prices are surging on a wide range of goods from lumber (affecting house-builders) to used cars, with new car production hit by shortages of critical semiconductors.

The CEO of Cummins (NYSE:CMI), an engine and generator manufacturer, says customers are trying to get everything they can because they think demand is going to extend into next year. Monster Beverage (NASDAQ:MNST) faces a shortage of aluminium can scarcity, and the chip shortage is also delaying tech firms’ new product releases. 

Portfolio action to consider, and stockpicking 

Tactics hinge on whether inflation is broadly fleeting, settles at a moderately higher level, or, in a worst-case scenario, accelerates to force radical change in monetary policy. 

A compromise view is modestly higher inflation suiting the authorities as a means to cope with humongous public debt – steadily “inflating it away” on the back of higher growth and tax receipts. But is that too cute to hope for? 

If price rises are transitory and deflationary themes return – such as technology advance reducing costs, and low bargaining power remaining low – there is little action you need take. Tech-stocks are liable to maintain premium ratings for growth in a low interest rate environment. 

This explains why high-profile US growth fund managers such as Cathie Wood are adding to their technology holdings – proclaiming some have potential to triple over the next five years. 

It appears very risky because higher inflation works against presently exorbitant ratings on growth stocks, also exposed in any financial crisis. Conservative investors would now top-slice the most highly rated and ensure cash reserves to take advantage of falls – generally among equities. 

Equities are still preferred as a means to cope with inflation 

Bulls might argue that if ‘buy the drop’ remains the strategy (like it has since end-2008) then its extent will be limited. Do not try to get clever with timing markets. Equities will be sought relative to bonds, and force cash off the side-lines too. The defensive asset class would consist of companies exposed to reflation underway; in essential products and services; able to pass on price rises to customers. 

With the UK government firmly intent on infrastructure spending, this is chiefly why ugly duckling construction group Kier (LSE:KIE) has suddenly been perceived with swan-like feathers emerging. Just recently it managed to raise £241 million in less than nine hours. The sector should broadly benefit. On which logic, equities in materials supply will also be preferred. 

There is currently talk of a new super-cycle under way in commodities, though it depends if economic growth is sustained. 

I am quite wary of the claim industrial equities will do well generally, since higher input costs confuse the value equation. 

Similarly, financials are meant to be a broad play on economic expectations. Fine, if inflation can be capped, but in a financial crisis they are in the eye of the storm.   

Infrastructure and related materials do look a priority sector to be examining, given they will enjoy support from post-pandemic policy. However, it seems premature to decide on industrials/financials until the inflation trend becomes clearer. 

Also, healthcare and pharmaceuticals, given this sector tends to offer reasonably priced growth – why in recent months I have advocated AstraZeneca (LSE:AZN) and Bristol-Myers Squibb (NYSE:BMY) in the US. 

Utilities are strongly positioned, too. One reason I advocated BT Group (LSE:BT.A) last November was it introducing annual price increases linked to inflation.

Gold is a traditional inflation hedge, again partly why I have advocated Centamin (LSE:CEY), Polymetal International (LSE:POLY) and Petropavlovsk (LSE:POG)

This gives you a sense of my inflation survival plan for the months if not years ahead, where we will need to stay attuned. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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