For bond investors, inflation is almost all bad news, eroding the value of future returns. For stock traders, the news may be less categorically horrible, given the ability of certain companies to extract profits from higher prices.
Although there are many casualties in the stock market if price pressures increase, history suggests that the scenario is not without opportunities. Energy stocks have been persistent winners during periods of high inflation for the past five decades, shows a study by Ned Davis Research.
Goldman Sachs Group Inc. recommends better-equipped companies to profit from sales as an automaker Ford Motor Co. and media company Discovery Inc. For Societe Generale SA, supply and demand imbalances suggest that mining stocks and fertilizer producers offer better coverage if pressures increase.
No matter how optimistic Federal Reserve President Jerome Powell it’s on the subject now, inflation will one day matter again for stocks. In recent weeks, hawks have seen worrying signs on everything from a global scarcity of computer chips for the biggest jump ever recorded in US producer prices.
With the economic outlook improving, cases of Covid-19 falling and more fiscal stimulus on the horizon, nervousness about inflation is creeping in. This means that pricing power is set to become “an intriguing alpha generator” due to the wide variation in how companies handle it, according to Tobias Levkovich, chief US equity strategist at Citigroup Inc ..
“Lead indicators suggest that a fear of inflation may be building,” wrote Levkovich. “Companies with price flexibility must come out as winners.”
Energy stocks have the best track record during periods of high consumer prices, according to Ned Davis. In seven of the nine cases of high inflation since 1972, the sector surpassed the S&P 500 by a median of 14 percentage points, the study showed.
When classified by investment style, stocks of cyclical value – companies whose sales are more sensitive to economic fluctuations and generally traded at relatively cheap valuations – tend to do better when inflation is high, Ned Davis noticed.
Crude oil soared this year, driven by confidence in a global economic recovery. These bets have been reflected in the stock exchange, with energy producers including Exxon Mobil Corp. and Marathon Oil Corp. The industry led gains in the S&P 500 in 2021, rising five times more than the stock benchmark.
Although the ramifications of inflation for the broader market are not straightforward, a look below the surface shows that investors are preparing for the result, favoring companies with high operating leverage or the ability to extract profits from revenue.
Although costs of sales and inputs tend to increase when inflation rises, companies with strong leverage potentially offer safer trade. The reason is: the effect of increased revenue would outweigh production costs.
Since the beginning of February, a basket of shares with the highest operating leverage that eliminates the industry bias has won the weakest cohort by 1.7 percentage points, data compiled by Goldman Sachs and Bloomberg show. The indicator is ready for a fourth consecutive month of superior performance, the longest sequence since the 2013 cholera crisis year.
Higher input costs, such as commodities, pose little threat to the overall profits of S&P 500 companies, in part because some sectors profit from rising material prices and others protect exposure, according to Goldman Sachs strategists, including David Kostin .
Labor costs, on the other hand, are a major adverse factor, with an increase of 100 basis points in wage growth likely to total a 1% reduction in corporate profits, their estimates show. Thus, they advise investors to favor companies whose labor costs represent a smaller share of revenue, such as Under Armor Inc. and Biogen Inc.
“Many investors believe that increased spending will lead to higher inflation and interest rates, which would reduce the value of equity duration and increase the importance of short-term growth,” wrote Kostin in a note earlier this month. “Historically, inflation has boosted nominal revenues for the S&P 500, but has weighed on profit margins, as companies struggled to raise prices at the same pace as input costs.”
Société Général strategists, led by Andrew Lapthorne, created a basket of stocks based on their sensitivity to metrics such as fluctuations in copper and food prices. Basic materials, technology and energy stocks currently represent two thirds of the portfolio.
Although the group has proven its worth by rising with inflation expectations in recent months, one drawback is its poor performance in times of disinflation – something that has dominated the market for much of the past decade, they noticed. To compensate for this deficiency, the strategists at Société Générale developed an operation dubbed “call replication” that limits the risk of withdrawal while maximizing the advantage.
“When we talk to investors, they want the upside of the price rises and would like to cover the risk of inflation, but most find volatility incompatible with their risk tolerance,” Lapthorne wrote in a note on Thursday. “Call replication strikes the right balance.”
– With the help of Sarah Ponczek and Elena Popina