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When veteran stockpicker Geoff Wilson began his career in the era of hyperinflation in the early 1980s, he was impressed that investors needed to be aware of the changing economic environment.
“I remember in the early ’80s being told that you always make your money in the second bull market,” he says.
“At first I didn’t understand what that meant. And it really meant that you lose all the money you make in your first bull market because you don’t recognize when things are changing,” he says.
Geoff Wilson: “When the genie comes out of the bottle, the impact on stock markets is significant.”Credit:James Alcock
Wilson mentions the anecdote when asked if he thinks stock market investors fully understand the implications of rising interest rates and inflation, which are perhaps the biggest issues in markets today.
“I think the market does, the professional market does. What worries me is that the retail investor doesn’t. We’ve seen a lot of new entrants into the stock market over the last few years,” said Wilson, chairman of Wilson Asset Management.
Many retail investors will, of course, disagree. But the comment underscores the changing world investors face as markets grapple with rising inflation and interest rates for the first time in years.
Inflation fears have been running high lately, fueled by rising commodity prices and the fallout from the war in Ukraine, with petrol costing around $2.20 a liter and companies warning of price hikes in sectors such as transport, retail and food.
The US Federal Reserve underscored the changing global environment as it hiked interest rates for the first time since 2018 this week. Futures markets are betting the RBA will hike interest rates for the first time in 11 years by July.
All of this will be unfamiliar to many investors who are more used to rates going the other way: AMP Capital says lower inflation has been a “tailwind” for stock market returns over the past four decades.
So if the market is right and inflation is rising now, what does this mean for the stock market? And which industries and types of companies are better positioned to benefit in an environment of rising costs?
HIGH FLYERS IN DANGER
Professional money managers say the most important impact of higher inflation, related to rising consumer prices, is how it changes the outlook for interest rates.
If inflation rises, central banks will try to keep it in check by raising interest rates, and bond yields will rise as well. As yields on safe-haven assets, such as bonds and bank deposits, rise, there is less incentive to take more speculative bets on companies that could make profits in the future, such as B. Loss-making technology companies.
Markets have already reacted dramatically in this direction, boosting companies like miners and banks while driving down the value of much-vaunted “growth” companies, many of which are in the technology sector. For example, shares in buy-now, pay-later business Zip Co are down more than 60 percent this year, while accounting software company Xero is down about 30 percent.
Wilson says that when markets started pricing in rate hikes, a trend that gained momentum late last year, it took “all the exuberance out of the stock market.”
Clime Asset Management founder John Abernethy says that rising government bond yields — known as “risk-free” assets — generally mean that investors are paying less for future profits, thereby driving down stocks’ price-to-earnings ratios.
Abernethy, another veteran investor who began his career in the early 1980s, predicts a return to more “fundamental” investing, including a focus on dividends.
“The value is back. We’ve moved out of the slack, dynamic and speculative phase and are now back to serious investing, picking stocks that can counteract inflation…or if it’s about being guided to fundamental growth in the economy,” he says.
Mark Freeman, managing director of the $10 billion public investment firm Australian Foundation Investment Company, also says investors place a premium on companies that can pass rising costs on to customers. He says there’s less interest in chasing stories about a company’s potential, especially when the company isn’t yet turning a profit.
“I think people become a bit more value-conscious in an inflationary environment. While last year things went up because they were,” says Freeman.
BANKS, MINER AND SUPERMARKETS AMONG THE PROFIT
While inflation is widely viewed as bad news for more speculative stocks, the ASX200’s traditional powerhouses should benefit. The most prominent examples in Australia are the big banks hoping for bigger profit margins as interest rates rise, and miners. Both sectors have so far outperformed in 2022.
Inflation has been dormant for a long time, but is now haunting markets and consumers again. Credit:Michele Mosop
The conventional wisdom is that commercial real estate companies and non-discretionary retailers like Woolworths and Coles should also benefit in a time of rising prices, while discretionary retailers are more likely to struggle.
However, some argue that these theories about inflation winners have limitations.
Portfolio manager at Airlie Funds Management, Matt Williams, says commodity companies are clearly benefiting from rising prices, but banks may have a harder time benefiting from rising interest rates. He points to stiff competition in mortgages, which has squeezed profit margins, and the potential for higher interest rates to reduce demand for mortgages.
As the unemployment rate fell to 4 percent this week, the lowest level since 2008, he also says companies with large numbers of employees such as Woolworths, Coles and Wesfarmers could face increasing pressure on their payroll costs.
“Will it be a big windfall for banks and supermarkets? I don’t think so,” says Williams.
Williams points out that even Wesfarmers-owned hardware giant Bunnings spoke last month about the need to minimize passed-on costs. “One might think that if any company could set prices without competitive effect, it would be Bunnings. Who are your competitors? They really shied away from that,” says Williams, who manages around $10 billion in funds.
In addition to questioning how broad sectors are handling inflation, stock pickers are also looking at whether individual companies have something that is always valued in investment markets: pricing power.
When related to a firm’s ability to set prices in a market rather than being dictated by competition, pricing power becomes even more desirable in times of rising inflation. Fund managers crave companies with pricing power, and everyone has their favorite picks from who has them today.
Williams points to companies such as James Hardie, ARB Corporation and Xero, while some of Wilson’s picks include lab testing company ALS Limited, Viva Energy and construction company MAAS Group.
Tribeca Investment Partners portfolio manager Jun Bei Liu says that size matters when it comes to pricing power, as market leaders can generally pass on costs with the least difficulty.
“You really need to stay with these companies because they can hedge against inflation,” she says.
Tribeca portfolio manager Jun Bei Liu. Credit:Jessica Hromas
Liu argues that companies like CSL and Seek have been tarred with the same brush as other growth companies in a rush to dump “growth” stocks — though she argues they are “almost immune to inflationary pressures.”
The critical question facing investors is whether the market’s view of inflation is correct. Wilson calls this the “million dollar question”.
With markets already pricing in much higher interest rates, a key risk is whether inflation will beat expectations.
Wilson, who is more skeptical of “growth” stocks, says high-flying tech stocks with higher price-to-earnings ratios would suffer if inflation is a bigger problem than markets are anticipating. “The larger the multiple, the greater the risk,” he says.
“When the genie comes out of the bottle, the impact on stock markets is significant,” says Wilson.
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