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Equity Comment: Winners and Losers from Inflation

What are we talking about? With inflation looking to be “higher-for-longer”, we’ve had some discussions about the winners and losers within equity markets.

A few comments:

First, there’s a view that equities can be a decent inflation hedge, especially companies can raise prices, but that can vary greatly by industry and company. The other wrinkle is that they can be a decent hedge until inflation reaches the point when Central Banks feel compelled to act by tightening monetary policy. That can prompt equities to fall, as their multiples de-rate and as their earnings potentially decline – depending on how aggressive Central Banks choose to be.

Second, some contradictory thoughts on winners and losers. The first thought is that “value” could outperform – particularly if inflation is demand-driven. It’s the “rising-tide-lifts-all-boats” argument – if inflation is rising, then everyone should see their revenues (although maybe not their volumes) improve.

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The second thought is that quality should outperform. In this context, inflation doesn’t help everyone – what really matters is whether companies can manage the difference between their revenue inflation and their cost inflation. If revenues beat costs, happy days. If not, it’s rather less pleasant. And in theory, “high-quality” businesses should be better able to do that. How do you measure quality? There are various ways, you might use financial metrics like gross margin or return on invested capital. From a macro perspective, it’s tempting to look at the spread between consumer and producer prices as a signal for whether or not corporate margins should rise or fall. Unfortunately, it’s not quite as a straightforward as that.

The third thought is that large businesses should do better than smaller businesses. Large businesses might be able to negotiate more aggressively with suppliers or they may be more diversified and less susceptible to cost inflation in one particular business.

The final thought relates to higher rates – if Central Banks do raise rates, what happens then? One line of argument suggests that it’s the highly-rated stocks that are at greater risk, as discount rates are rising. It’s never that simple, of course, but it might be a scenario in which well-loved tech stocks have a tougher time than the more lowly-rated value names.

Where does this get us? We’ve kept our equity exposure unchanged in our most recent rebalance, reflecting a view that inflation won’t be a significant headwind for equities for now. On the beneficiaries, we generally prefer the arguments in favour of quality and size. We can see the case for value, and we still have some value exposure, but we think the challenge of managing in a more inflationary environment still favours the “better” businesses.

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