UK Plc Ill-equipped to Deal with Inflation, says Ardevora

Investors, quite rightly, are beginning to fret about inflation – a reversal of the benign environment we have witnessed over the past decade

External Writer 11 July, 2018 | 12:46PM

This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here Jeremy Lang, partner and co-founder of Ardevora Asset Management discusses rising inflation.

inflation UK businesses ill-equipped to deal with rising costs prices FTSE 100

Over the last few months financial markets have started to believe inflation may be coming back. The first evidence was in bond markets. Long bond yields are sensitive to changes in inflationary expectations and have been rising.

Shares in utilities and low growth defensives, like staples, are sensitive to long bond yields. Investors often invest in defensive stocks for dividend yield and seek to compare those yields to long bond yields to get a sense of fair value. This explains why many of the classic defensive areas of the market have struggled over the past six months or so.

Bond investors, quite rightly, are beginning to fret about inflation – a reversal of the benign environment we have witnessed over the past decade. The anxiety has switched from ‘have we got enough growth?’ to ‘is there too much growth?’, fearing the impact this might have.

Inflation generally emerges in two ways – cost push or demand pull. For many companies the two biggest costs are raw materials and wages and there is clear evidence of upward pressure on both. Commodity prices, particularly oil, have been rising steadily over the past year. The same is true for wages – with references of ‘wage cost pressures’ in corporate reporting going up significantly over the past couple of months.

Can Oil Protect Against Inflation Risk?

For investors looking to hedge some inflation risk, the first move would be to go back into commodities – which is heavily dominated by oil. However, while oil has been steadily rising over the past year, there has been a disconnect between the oil price and the share prices of stocks within the energy sector, which have been largely unmoved until very recently.

Profitability within the energy sector – particularly the services companies – has been difficult due to the lack of pricing power. There are still a lot of businesses struggling in the sector, even though final output is going up – with issues such as increased competition and balance sheet stress. US shale production is ramping up again. Usually this would be a worry. However, three years of stress in the oil industry has bled reserves from more expensive off-shore oil companies. A supply gush is less of a concern now. 

Sectors Likely to Struggle on Rising Costs

As anxiety in the market has changed in regard to inflation, it has negative implications for a number of other sectors – especially industrials and consumer staples. We are seeing more companies report wage and input cost pressures, as well as an inability to fully pass costs on. This will be a recurring theme as we move through the year.

Bizarrely, the sector most people worry about, tech, is the one most insulated from rising cost pressures. Tech is used to wage pressure, as it has always been a high-wage sector. In an environment where cost pressures are high, operational leverage is your friend and tech is the sector exhibiting strong growth.

Consumer staples are the opposite, as companies are struggling to achieve any unit volume growth. There are also a number of structural pressures on staples, Amazon is causing more pricing pressure and own brand supermarkets like Aldi and Lidl are challenging demand.

Does the UK Market Offer Immunity?

When looking at the UK equity market specifically, your first instinct is to be pessimistic because of the ongoing uncertainties surrounding Brexit and the mediocre performance of the domestic economy. However, putting the pieces together, the UK market offers a fairly decent inflation hedge – due to its large weighting to natural resources.

You also get a hedge against domestic issues, as major concerns over the economy often lead to weakness in sterling, which then boosts the large proportion of overseas earners in the UK large cap index.

The End of High-profitability Era

Investors globally have fretted for a considerable amount of time about the market’s super-high levels of profitability. Those anxieties may finally be justified as cost pressures build.  

Inflation has steadily come down since about the early 1980s, so there are many businesses not used to having to deal with it. Various areas of the market are going to start to react differently as we move through the rest of the year. Business that have relied on pumping up margins without volume growth should be avoided. The same can be said for companies that have relied on cheap leverage to purchase companies to then rip out costs and push up margins.

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