Beating inflation with ‘price-makers’
Interest rates rise in tandem with commodity prices, which boost emerging market currencies but affect margins elsewhere. Sectors such as tobacco offer protection from these pressures.
Rising commodity prices are hitting emerging markets and forcing central banks to raise interest rates in an effort to tame inflation. This strengthens undervalued currencies to the detriment of exporters. Higher prices also put margin pressure on other corporates whose biggest costs are commodities.
Cost rises can be relatively benign if they can be passed on to the end user. But in emerging markets, where domestic demand remains weak, this is problematic. The Producer Prices Index and the Consumer Prices Index are both rising but the gap is widening. Rising commodity prices are less corrosive to companies in America and Europe because wages are their biggest costs. The risk of margin erosion is lower, so - in the absence of wage inflation in the West - developed market companies should continue to outperform their emerging market counterparts.
Inflation is not only a problem for developing economies. But in Britain, at least, markets are overestimating the interest rate risk. Bond markets are pricing in 200 basis points of British rate hikes in the next 18 months. No doubt rates will rise, but it is unlikely that the Monetary Policy Committee (MPC) will hike this aggressively. VAT has already risen and the spending cuts will continue to squeeze the lower and middle income groups.
In this environment, the MPC will stagger rises carefully, waiting an appropriate length of time between each hike to assess its impact on inflation and growth.
Against the uncertain investment backdrop, a sensible strategy is to invest globally and in sectors that are less sensitive to higher interest rates, rising commodity prices and lower consumption. Particularly attractive are firms able to pass on rising costs to the end user without lowering demand. Swiss watchmakers, for instance, can increase prices by 10% safe in the knowledge that it will not dent sales, as their customer base is not driven by cost considerations. Tobacco companies are similarly well-positioned; evidence suggests price rises have little or no impact on the number of people smoking. Such “price-makers” can be found even in fragmented sectors where firms typically do not enjoy inelastic demand. Arcelor Mittal, for instance, can pass on a higher percentage of costs than its competitors simply because it is the dominant business in its sector.
Conversely, firms dependent on highly elastic demand are less attractive, as they are “price-takers” unable to pass on rising costs to the consumer. Airlines and most consumer-related sectors must also absorb costs and are thus unattractive in an inflationary environment.
Investment grade corporate bonds can benefit from positive supply/demand dynamics - driven by the huge shift in pension fund allocation towards corporate bonds and the estimated negative net issuance this year - and the fact balance sheets are in excellent health.
Geographically, a British overweight is warranted in light of cheap bank bond valuations and the coalition’s efforts to slash the deficit. In contrast, the ballooning American deficit is a big concern and American credit looks fair value, suggesting investors should adopt a neutral position. In Europe, peripheral countries are still struggling with sovereign debt but there should be a positive outcome for the European Financial Stability Facility, while the broader refinancing risk - having been addressed over the past two years - is fairly low. Europe offers tactical opportunities with some new issues offering good value, but caution is required.
With global growth recovering, lower-rated investment grade bonds should outperform A and AA-rated debt, with spreads tight. Moreover, many higher-rated companies are awash with cash and there is a strong risk they will seek to engage in shareholder-friendly behaviour or mergers and acquisitions - both bearish for bondholders. In contrast, BBB-rated companies must focus on retaining their investment grade status and are more cautious in managing their capital structure.
While many bondholders are, on valuation grounds, long high-yield credit, BBB names offer better value on a risk-adjusted basis. Financials remains an attractive trade, with forthcoming regulation supportive of subordinated debt. Financials offer value at both ends of the capital structure, with the emergence of high-yielding covered bond issuance within the senior secured space, and coco (contingent convertible) structured hybrid securities at the lower end.
At the high end, some senior secured bonds are being issued at the same yield as their equivalent unsecured bond, reflecting banks’ need to refinance and investors’ lack of appetite for unsecured paper. This dynamic is particularly notable among some European banks and homework must be done to find the best opportunities. In a reflationary world in which country-specific risks are high, it makes sense for investors seeking higher yields and lower risk to take a global, rather than regional, approach.
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