‘The million dollar question’: How hard will inflation hit the market?


When veteran stockpicker Geoff Wilson started his career in the high-inflation era of the early 1980s, it was impressed on him that investors needed to be aware of changes in the economic backdrop.

“I remember back in the early 80s, I was told you always make your money in the second bull market,” he says.

“Initially I didn’t understand what that meant. And it really meant that whatever money you make in your first bull market you lose because you don’t realise when things are changing,” he says.

Geoff Wilson: “If the genie does get out of the bottle, then the implications for equity markets are significant.”

Geoff Wilson: “If the genie does get out of the bottle, then the implications for equity markets are significant.”Credit:James Alcock

Wilson brings up the anecdote when asked if he thinks sharemarket investors fully understand the implications of rising interest rates and inflation, which is perhaps the biggest theme on markets today.

“I think the market does, the professional market does. What concerns me is the retail investor doesn’t. We’ve seen a lot of new participants in the equity market over the last couple of years,” says Wilson, chairman of Wilson Asset Management.

Many retail investors will naturally disagree. But the comment underlines the changing world facing investors, as markets grapple with rising inflation and interest rates for the first time in years.

Fuelled by surging commodity prices and fallout out from war in Ukraine, inflation fears have gone into overdrive lately, with petrol costing about $2.20 a litre, and businesses warning of price rises across sectors such as transport, retail and food.

The US Federal Reserve underscored the changing global environment when it this week lifted interest rates for the first time since 2018. Futures markets are betting that by July, the RBA will raise the cash rate for the first time in 11 years.

This will all be unfamiliar for many investors more accustomed to rates heading in the other direction: AMP Capital says lower inflation has been a “tailwind” for sharemarket returns for the last four decades.

So if the market is correct, and inflation is now on the rise, what will it mean for the share market? And which sectors, and types of companies, are better placed to profit in an environment of rising costs?

HIGH-FLYERS AT RISK

Professional money managers say the most important impact of higher inflation, which refers to rising consumer prices, is how it changes the outlook for interest rates.

When inflation rises, central banks try to keep it in check by raising interest rates, and bond yields will also rise. As returns on safe assets such as bonds and bank deposits increase, it reduces the incentive to make more speculative bets on companies that might make profits in the future, such as loss-making tech firms.

Markets have already reacted dramatically along these lines, by boosting businesses like miners and banks, while slashing the value of much-hyped “growth” businesses, many of which are in the technology sector. For example, shares in buy now, pay later business Zip Co have tumbled more than 60 per cent this year, while accounting software firm Xero is down about 30 per cent.

Wilson says that once markets started to price in interest rate hikes, a trend that gained momentum late last year, it took “all the exuberance out of the equity market.”

Clime Asset Management founder John Abernethy says rising yields on government bonds – known as “risk-free” assets – generally cause investors to pay less for future earnings, thereby lowering price-to-earnings multiples on equities.

Abernethy, another veteran investor who started his career in the early 1980s, predicts a return to more “fundamental” investing, including a focus on dividends.

“Value is back. We’ve gone from the lackadaisical, momentum, speculative period, now we’re back to serious investing about picking stocks which can trade off inflation… or be levered to fundamental growth in the economy when it comes,” he says.

Managing director of $10 billion listed investment firm Australian Foundation Investment Company, Mark Freeman, also says investors are putting a premium on companies that can pass through rising costs to customers. He says there is less interest in “chasing stories” about a firm’s potential, especially if the company is not yet making profits.

“I think people become a bit more value conscious in an inflation environment. Whereas last year, things were going up because they were,” Freeman says.

BANKS, MINERS AND SUPERMARKETS AMONG WINNERS

While inflation is generally seen as bad news for more speculative stocks, the traditional powerhouses of the ASX200 are expected to benefit. The most prominent examples of those in Australia are the big banks, which are hoping for wider profit margins as interest rise, and miners. Both sectors have outperformed so far in 2022.

Inflation has been dormant for a long time, but is now haunting markets and consumers again.

Inflation has been dormant for a long time, but is now haunting markets and consumers again. Credit:Michele Mossop

The conventional wisdom is that commercial property businesses and non-discretionary retailers such as Woolworths and Coles should also benefit at a time of rising prices, while discretionary retailers will tend to struggle.

However, some argue these theories on the winners from inflation have their limitations.

Portfolio manager at Airlie Funds Management, Matt Williams, says resources companies are clearly benefiting from surging prices, but banks may find it harder to cash in on rising rates. He points to the stiff competition in mortgages, which has been crunching profit margins, and the potential that higher interest rates cut the demand for mortgages.

As the unemployment rate this week plunged to 4 per cent, its lowest since 2008, he also says companies with large numbers of staff, such as Woolworths, Coles and Wesfarmers, could face mounting pressure on their wages bills.

“For banks and supermarkets, is it going to be a big windfall? I don’t think so,” Williams says.

Williams points out that even the Wesfarmers-owned hardware giant, Bunnings, was last month talking about the need to minimise the costs it passed on. “You’d think if any company could put up pricing without a competitive effect it would be Bunnings. What competitor do they actually have? They actually really shied away from that,” says Williams, who oversees about $10 billion in funds.

As well as thinking about how broad sectors can handle inflation, stock pickers are also looking at whether individual businesses have got something that is always prized in investment markets: pricing power.

Referring to a company’s ability to set prices in a market, rather than have them dictated by competition, pricing power becomes even more desirable at a time of rising inflation. Fund managers crave companies with pricing power, and all have their favourite picks as to who has it today.

Williams points to firms including James Hardie, ARB Corporation, and Xero, while some of Wilson’s picks include laboratory testing business ALS Limited, Viva Energy, and construction business MAAS Group.

Tribeca Investment Partners portfolio manager Jun Bei Liu says that size matters when it comes to pricing power because market leaders can generally pass on costs with the least trouble.

“You absolutely need to stick with these businesses because they will be able to inflation hedge,” she says.

Tribeca portfolio manager Jun Bei Liu.

Tribeca portfolio manager Jun Bei Liu. Credit:Jessica Hromas

Liu argues that in the rush to dump “growth” stocks, companies such as CSL and Seek have been tarred with the same brush as other growth businesses – even though she argues they are “almost immune to the inflation pressure.”

The critical issue facing investors is whether the market’s view on inflation is correct. Wilson calls this the “million dollar question.“

Since markets are already pricing in much higher interest rates, he says a key risk will be whether inflation exceeds expectations.

Wilson, who is more sceptical about “growth” stocks, says that if inflation ends up being a bigger problem than markets anticipate, high-flying technology stocks on higher price-to earnings multiples would feel the pain. “The bigger the multiple, the greater the risk,” he says.

“If the genie does get out of the bottle, then the implications for equity markets are significant,” Wilson says.

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