Investment guide: Stocks and instruments to look at during periods of high inflation

It might be cliche, but it’s worth saying again. Rising inflation is the biggest challenge of our times, and investors of the current generation are experiencing something they might not have seen in their entire lives.

The pace of increase in prices in the US is the highest in four decades. Yet, most market participants are conditioned to a world where inflation was consistently below or near the Fed’s 2 per cent target. The changed scenario
calls for a new investment paradigm. Higher prices mean the US Federal Reserve will combat inflation by aggressively raising the Federal Funds rate and tapering bond purchases.

Moreover, the US Central Bank might also reduce the monetary policy accommodation by reducing the balance sheet size. This process, termed ‘quantitative tightening’, involves selling bonds, which will reduce the amount of money in the economy. This operation is the exact opposite of ‘quantitative easing’.

The net impact of these moves will be a rise in US Treasury yields, raising the cost of money. Or in other words, an average layperson will have to cough up higher interest charges on their loans.

BUSINESSES TO WATCH
The challenge for an investor is to identify suitable investment themes in this climate. For example, companies with low debt-equity ratios will outperform due to lower interest costs. On the other hand, those firms with a high base of fixed assets financed through loans will see their interest costs spike and net profits decline.

So, investors should avoid them. Service sector businesses tend to have lower debt on their balance sheet. Microsoft is a classic example.Banks and insurance firms could see a sharp improvement in their bottom line. Currently, the short-term yield has risen faster than long-term ones, resulting in a flattening yield curve; however, that could change in the coming quarters, especially when the Federal Reserve starts reducing its balance sheet. In addition, through quantitative tightening, bonds of longer tenor are sold, which raises the long-term rates, resulting in steepening of the curve. Practically, it means that the difference between short and long-term yields will rise in the next few quarters. The rising spread is a bullish scenario for banks, as they borrow short-term and lend for longer.

Insurance companies also will see their profits rise since they will be able to invest premiums from their customers into higher-yielding debt securities.Another set of businesses that will do well are companies with strong brands. Good examples would be companies such as McDonald’s and Coca-Cola. These companies have good pricing power, and in an inflationary environment, they will be able to raise prices and protect their profit margins.

Inflation-linked bonds (or ILBs) issued by sovereign governments, such as the US and the UK, are another way to protect against inflation.

Investors should avoid growth stocks or companies with a high valuation. These companies have the bulk of their cash fl ow forecast in the distant future. When long-term yields rise, their future cash flows get discounted at a higher rate, which compresses their valuation. Electric vehicles and early-stage fintech companies are some examples.

RELIABLE CHOICES
JPMorgan Chase, the largest bank in the US, with $3.74 trillion in assets at the end of 2021, is an appealing prospect for investors. The bank has quadrupled its quarterly dividend payment over the last decade, sending out a message that it is serious about sharing its success with shareholders. The current dividend yield of 2.7 per cent is also healthy. Furthermore, a solid balance sheet is one of JPMorgan Chase’s most vital assets, which will likely become even more impressive when the company starts investing in technology infrastructure to improve performance and efficiency.

Microsoft is one of the best-positioned cloud titans for the next decade. Microsoft’s dramatic growth over the past seven years was led by expanding its cloud services, including Azure, Office 365, Dynamics, LinkedIn, and its other cloud-based software. The company reports these businesses together as the Microsoft Cloud. For the quarter ended December 31 [in 2021], Microsoft reported revenue of $51.7bn, up 20 per cent from the corresponding period in the previous year, with profits of $2.45 a share. The most impressive aspect of its business is its strong free cash fl ow which has helped it have a rock-solid balance sheet. The cash in the balance sheet is at $125bn, compared with the debt of $80bn, making it a net cash company.The Walt Disney Company creates magical and adventurous fantasies and rides, helping it have excellent brand equity among its clientele.

Moreover, relaxation of lockdowns and rising vaccination rates will allow Disney’s primary businesses, movies, cable, and theme parks, to be revitalised in the following quarters. Spider-Man: No Way Home, produced by Disney and Sony, is the first film in the pandemic era to deliver a gross of $1bn at the box office. The business is inextricably linked to consumer spending power in the US and worldwide, which will benefit from wage inflation across the world.Starbucks Corporation, the American multinational chain of coffee houses, enjoys excellent customer loyalty.

The company posted record fourth quarter earnings [in 2021] to the tune of $8.1bn, driven by a 22 per cent year-over-year increase in US store sales. The company still expects to grow revenue in FY 2022 by 11.8 per cent to 13.6 per cent, while sustaining a 17 per cent operating margin. However, Starbucks expects its operating margin will improve to between 18 per cent and 19 per cent by FY 2023. And the rising operating margins are despite a spiking wage bill, which shows its superior pricing power.

Nadeem Khan is the executive director at Century Financial

Taken from GB Invest February 2022 edition