Invest-ability daily 24/09/21: Panic Stations

Why investors need to be on guard against sticky inflation

Panic at the pumps

When anyone in government publicly states that there’s no need to panic buy, as small business minister Paul Scully did this morning, you can be pretty sure the end result will be a wave of panic buying. As you can see above, the queues are already forming at the local garage as the news of petrol station closures filters out. Every conversation I overheard in the Co-Op was about potential fuel rationing. 

Meanwhile the energy market is in chaos, as Phil and I discussed in this week’s Quality Shares podcast along with our views on inflation. We’ve feared for some time that it could be stickier than central bankers have been prepared to admit so far, not least because we see a labour force with greater bargaining power than it’s had for many years. And when wages rise, they rarely fall again.

The official view does now seem to be shifting. The Bank of England has already said that core inflation will jump above 4 per cent this winter as a result of higher energy bills and remain elevated until the middle of next year, even though economic activity is being supressed by the supply chain crisis. The monetary policy committee kept interest rates on hold in the latest meeting this week, but it did acknowledge that the case for a “modest” increase in the next few years had strengthened.   

There is, of course, a word for this unpleasant combination of rising prices and slowing growth: stagflation, and the threat of a serious dose of it is very real even if policymakers daren’t admit it. Leading economist Nouriel Roubini warned as much this week. “The Panglossian scenario that is currently priced into financial markets may eventually turn out to be a pipe dream” he wrote in the Guardian.

This all matters to investors for various reasons. Firstly, there is the immediate impact of rising costs hitting company profits – in many cases companies are so far holding firm with 2022 guidance, and it may well be that some can adapt to the difficulties or raise prices to customers to do so.

But that seems unlikely across the board, especially in competitive industries where firms don’t have much pricing power or labour-intensive ones where making extra sales requires extra staff (unlike the operationally leveraged ones we’re always on the lookout for). Supermarkets, for example, sit uncomfortably in the middle of both categories, and is one of several sectors where we see the potential for earnings downgrades.

Then there is the mathematical effect on company valuations. The real value of future profits come down in times of inflation, which is why it’s generally bad news for stock markets, and especially today’s market when many companies trade on high earnings multiples – or, in converse, low earnings yields – which will be underwater in an inflationary environment. Phil’s hunch is that it may in fact be cheaper shares like DFS Furniture – where the low rating equates to an above inflation earnings yield – that could do best should the sticky-inflation scenario come to pass.    

That’s also why we’re not single-mindedly focused on so-called quality shares – generally also expensive shares. As we’ve said before, investors need a strategy that works for them, and the quality approach has been a good one for many – but investors also need to be both pragmatic and opportunistic when market moods change. Be prepared, and you wont need to be panic buying or selling shares when it does.

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