Style Winners and Losers From an Inflation-led Recovery

Expectations of a rebound in economic growth have seen inflationary expectations begin to rise. This has implications for the Value/Growth cycle within equity markets, with clear style winners and losers in the medium-term.

Although we have seen some moderation in magnitude of inflationary expectations creep back into financial markets just in the last month, consensus is that the economic recovery from the COVID-19 pandemic and the large fiscal stimulus will have a significant inflationary impact.

Inflation's Role in Recovery Supported by on The Ground Evidence

In March, my investment colleague Will Baylis discussed MCA’s expectations for rising inflation in his blog, The Inflation Genie Is Out Of The Bottle.

Over the last few months, we have started to see how governments and central banks are putting the brakes on stimulus & quantitative easing, and bond markets have begun to price in these inflationary expectations, resulting in falling bond prices and rising bond yields.

Inflation is also being supported by what we are hearing about the recovery at a ground level, with countless anecdotes around rising prices from the investee companies we meet with. Activity levels everywhere are at extremes, and everything is going up, from the lack of supply in construction materials pushing up the cost of timber, tiles & steel; to agricultural commodities driving food prices, and rising oil prices impacting freight costs. There is a similar expectation that rising wages this year will also contribute to higher costs flowing through to consumer prices.

Inflation and Recovery Key Factors in Value/Growth Rotation

Importantly, the shift in inflationary expectations has not gone unnoticed in equity markets. As the recovery gathers pace, both Australian and global equity markets have seen a distinct rotation out of Growth-style companies and sectors toward Value-style companies and sectors.

Growth sectors (such as technology) had performed well in the low economic growth environment, and their valuations have benefitted from the low interest rates on offer. In contrast, typical Value (cyclical sectors) have underperformed through the downturn due to poor growth expectations.

However, due to the strong relationship between nominal GDP growth, PMI and the performance of the Value-style relative to Growth, inflation expectations have now helped to shift the dial in Value’s favour.

Despite the minor pull back in Value-style relative performance in the month of April, we feel that rising inflation and economic recovery will be an ongoing theme for at least this year and into the next, and as a result equity markets will likely continue their rotation from Growth sectors towards more cyclical, Value-like sectors.

With this medium-term inflation in mind, we have looked at which sectors are likely to be the winners and losers from inflation and the ensuing Value/Growth rotation.

Likely Inflation and Recovery Winners

• Financials/Banks (e.g., NAB, ANZ): The prospect of higher interest rates driving better net interest margins (NIMs) has already helped position the sector for future profits. Similarly, the reversal of bad credit provisions and relaxation of credit restrictions taken during the pandemic should drive out performance.
• Energy sector (e.g., Viva Energy, Woodside, Worley): The recovering economy will drive a greater demand for fuel. The resumption of travel will also drive demand for aviation fuel.
• Steel/building materials (e.g., Fletcher Building): Government stimulus spending on infrastructure projects and a strong housing market is driving demand, and prices, for construction materials.
• Travel sector (e.g., Flight Centre, Star Entertainment): As economies reopen and border restrictions lift, we expect the sector to be a beneficiary of pent-up travel demand. On top of this, the COVID-19 pandemic has allowed organizations to reshape their cost base, which should drive high levels of profitability as travel trends normalise.
• Shopping centre REITS (e.g., Vicinity Centres): Despite many shopping centre tenants experiencing strong rebounds in retail sales, the landlords have lagged. Concerns on vacancies and rental spreads overhang the retail recovery story for the landlords, which we think is overdone.

The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the security transactions discussed here were, or will prove to be, profitable.
 

Likely Inflation and Recovery Losers

• Supermarkets: The supermarket sector is now lapping strong comparable periods in March/April where lockdown stockpiling was a big theme driving sales. The higher costs associated with COVID-19 preventive measures remain after the sales have returned to normal.
• Technology stocks: During 2020, tech stocks generally outperformed the rest of the market as investors sought growth in a low-growth environment. With cyclical industrials back in growth, we expect a rotation out of tech stocks. Similarly, low interest rates had been a benefit for asset valuations but will now be likely to drive a multiple contraction.
• Utilities: Given strong, reliable cash flows, utilities have been the recipient of strong interest from equity investors looking for yield. However, as bond yields increase on the back of rising inflation, this sector could see investors return to bond markets and share price underperformance.

Value Still in The Poll Position

While the rotation to Value over the last few months has delivered strong outperformance for Value-style investors, we believe there is still more to go for the stye.

Similar to what our CIO Reece Birtles discussed in his THE TIME IS NOW FOR VALUE blog back in February, our MCA Valuation spread, which measures the gap between the cheapest and most expensive parts of the market, is still lagging the upward trend in GDP, PMI and bond yields, whereas history suggests we should see a much tighter correlation in a recovery.

The timings of style cycles are notoriously hard to predict, but the recent pause in the rotation provides an opportunity for asset allocators to get positioned in quality Australian Value stocks and capitalise on the expected narrowing of the Value spreads before it is too late.  

Now continues to be the right time for Value.