Inflationary pressures are real and are looking increasingly persistent rather than transitory. Investors need to be wary of the assumption that all equities can weather an inflation storm.
- Stock markets have weathered inflationary pressures well so far in 2021
- Inflation appears to be increasingly persistent and central banks may be forced to act
- Not all companies can thrive in this environment, so investors need to pick with care
Inflation is now over 5% in the UK. This is considerably ahead of the Bank of England’s targets and also ahead of its expectations. To date, stock markets have largely shrugged off this inflation peril – but could that be about to change?
The usual narrative is that stock markets are better placed than most other asset classes to weather inflationary pressures. They may have rising input costs as wages and goods prices rise, but they can usually pass these off onto consumers and continue to grow earnings. Equally, the greater risk from inflation is rising interest rates, but central banks seem prepared to hold off on rate rises to see whether inflation will ebb by itself.
So far, so good, and stock markets have continued to make progress even with US CPI running at over 5% since May. However, investors cannot entirely shrug off the impact of inflation on equity markets. Not all companies can pass on costs and there is a point at which the consumer decides they will no longer absorb rising prices and stops spending.
Central banks cannot hold off on rate rises forever. The Federal Reserve has already dropped ‘transitory’ from its guidance on inflation. The labour participation rate in the US remains low, which is likely to continue to push up wages, particularly for low-skilled jobs. Central banks may be able to wait a little, but they cannot let inflation become unmanageable.
This does not suggest a benign backdrop for stock markets in 2022. However, as always, there will be winners and losers. Among the winners are likely to be those companies that are at the front of the queue with suppliers. They will be the ones with goods to sell, while smaller companies struggle with stock availability. Companies with real assets – pipelines, property, plant and machinery – should also fare well in this environment. Pricing power is also important, though it is often difficult to judge the stickiness of demand until a crisis hits.
The losers will be those with poor supply chain management, who can’t get hold of products to sell. Equally, it may be a more difficult time for the ‘bond proxies’: if yields start to rise in bond markets, investors may flip back to fixed income. It is an environment where the strong are likely to get stronger.
Investors cannot afford to be complacent about inflation. It may be a difficult adjustment – investors haven’t had to factor inflation into their decision-making for more than thirty years. Some careful stockpicking may be required in the year ahead.