How to turn the inflation headwind into a tailwind

In our recent reader survey conducted at the end of 2021, investors just like you (and perhaps, even you yourself), told us that inflation was their number one concern for markets in 2022. 

In fact, ABS research shows that easing COVID-19 restrictions have resulted in the largest increase in fuel prices in 30 years, while supply chain challenges continue to weigh heavily on various parts of the market. 

Think anything from technology, which has seen its benchmark plummet more than 25% since mid-November, to food and domestic goods, which have both seen prices skyrocket (it may surprise some to learn that butchers and restaurants are seeing up to 30% price increases for prime cuts of beef). 

So how can you turn this inflationary headwind into a tailwind for your portfolio? Glad you asked. 

In this episode, Livewire's James Marlay was joined by Monash Investors' Shane Fitzgerald and WILSONS' John Lockton for a deep dive on inflation. 

They discuss everything from how concerned you actually should be about what some dub the market's kryptonite, to the sectors and stocks that could actually benefit from inflation over the months to come.  

Note: This episode of Buy Hold Sell was shot on Wednesday 16th February 2022. You can watch the video, listen to the podcast or read an edited transcript below.

Edited Transcript

James Marlay: Hello, and welcome to this thematic discussion brought to you by Livewire Markets. My name's James Marlay, and today we are going to be talking about what most of Livewire's readers think is the number one headwind facing their portfolio in 2022, and that's inflation. Joining me to talk about inflation and how you can turn it from a headwind into a tailwind is Shane Fitzgerald from Monash Investors and John Lockton from WILSONS. John, a quick one to start off with, on a scale of one to 10, how important is thinking about inflation in a portfolio for you?

John Lockton: Seven out of 10.

James Marlay: So pretty important. Shane, same question for you? 

Shane Fitzgerald: Time matters, but right now, I'd say nine. But later on, four or five.

James Marlay: So my next question was going to be, do you think the focus on inflation is warranted or overblown? Dig into it for me. Why is it a nine for you?

Shane Fitzgerald: What the market cares about most is changing expectations and deltas. So we haven't seen inflation for decades in any meaningful way. Inflation has reared its head now. So it's a topical concern. It's also a topical concern because it affects all companies and affects bond rates and all the rest of it. 

Once inflation has stabilised or has come to some normalisation level, the market will move on. It won't become an issue at all.

James Marlay: So it's about the change for Shane. John, same question for you. Is it overblown or warranted? It's in every headline on Livewire, in the newspapers. We're all talking about it.

John Lockton: They are all the signals which tell me it could well be overblown, which is why I gave it a seven, but to Shane's point, we do have a global central bank situation, which is probably arguably behind the curve and somehow they've got to get up to the curve. 

We can all talk about supply issues easing in the second half of the year. But the reality is, inflation's really high and the central banks haven't done anything yet. So it is important at the moment.

James Marlay: Let's get into the practical steps investors can take. We've agreed, inflation, there's a change taking place, something we need to have a bit of a think about at the portfolio level. John, we'll stay with you. Give me a couple of practical steps that you think investors can do to assess how vulnerable their portfolio might be to change.

John Lockton: Ironically, James, in this environment, the stocks which have been out of favour for the last two or three years are actually more likely to be in favour. So practical steps, what we're doing in the portfolios we recommend to clients is we've actually done a bit of a tilt over the last six months from some of those higher growth sectors into some of those sectors which are cheaper. They don't have the same structural, long-term tailwinds, but in a rising inflationary environment, they could actually do quite well. So whether that be resources or energy or even the financials, in terms of the big four banks, they actually look a little bit better, we think, relative to the rest of the market versus what they were six months ago.

James Marlay: Just to finish that off, on the re-weighting process, is it a full swing? Is it a little bit of a light haircut? Like a number two, I had on the sides? What are we doing?

John Lockton: I think you can go a bit harder on that, particularly on energy. 

We think there's a real structural shortage of oil about to emerge and we're seeing the oil price rally significantly. We actually think there's more in that. So whether you want to own Santos (ASX: STO) or Woodside (ASX: WPL), we think they're two clear beneficiaries here, locally. 

You need to be at least square, if not over on the broader material space. So whether you want to play that through BHP (ASX: BHP) or Rio Tinto (ASX: RIO) or some of the other names, and then on the banks, we think you at least need to be market weight the big four banks.

James Marlay: Shane, same question for you. Just standing back for people to diagnose the portfolio and how susceptible it could be to this headwind, what are some of the things that you do internally when you're looking at your portfolio on this topic?

Shane Fitzgerald: Well, we start off by looking at how long we think inflation's going to be top of mind in the marketplace. Obviously, it's up high at the moment because of supply chain issues and all that playing out. And that's, I think, why the central banks haven't acted too hard, because they can see there's some element of short-term nature to the inflation pushing through. That said, if the supply chain stays messed up for too long, inflation feeds on itself and becomes self-perpetuating. 

So what do you do? You do what you always do. You do bottom-up analysis of the stocks you own. Do they have pricing power or they don't? 

If we're in a high inflation market, pricing power is everything. So that's what you want to look at. 

You want to do a review of your portfolio. Ask yourself, do the stocks I own have pricing power? In the short term, any stock you own that has a high PE multiple or high valuation is going to come under pressure, because high inflation means higher interest rates. Higher interest rates affects the DCF.

James Marlay: Shane, we're in the midst of reporting season, so I suspect you're hearing from a lot of management teams and CEOs about these specific issues. Are they giving you any clues as to whether or not they think they can pass price increases through to customers?

Shane Fitzgerald: It's the usual suspects that have been increasing the prices. What I'm hearing more is, most of the CEOs are saying they're seeing these things start to naturally resolve themselves. The supply chain is freeing up. Little things, like international borders, are opening up. There are more passenger planes flying around. There's more cargo hold in those passenger planes. So everything's starting to unwind and improve, but it'll take time.

James Marlay: Let's talk about some of the rotations that people have been moving their money into, and John alluded to it. We've seen the energy sector and materials doing really well. On the flip side, healthcare, IT, has not been so good. Do you think some of these moves are sustainable? And are some of these beaten-down sectors worth picking over?

Shane Fitzgerald: They were justified in the sense that when you have a high duration growth stock, whether or not it's trading on 30 times EBITDA or 25 times or 20 times EBITDA or pick your valuation metrics. Value's in the eye of the beholder in that regard. 

Whenever there's this change in valuation expectations of the market, those stocks will all get hit, but they're also the ones you're going to look for opportunities first, because, at the end of the day, a lot of these stocks are still growth stocks. 

They're still growing, and some of the old economy stocks that do well in an inflation environment, once inflation peters out or stabilises at a two, three or four per cent level, they become ex-growth again, and the money will flow back again.

James Marlay: John, you talked earlier about rotating to some of these more cyclical sectors. What's going to be the point in time where you choose to start picking over the carcasses of some of these high growth sectors that have been the funding source for the rotation that you've made?

John Lockton: For us, it's just looking at the central banks, understanding where they set cash rates and the timing around that. So to Shane's point, when we've got confidence that that journey is now clear, which it's not at the moment, then some of those high growth stocks, which are down 30%, 40%, and 50%, which still have growth ahead of them, that's when their time will come back in the sun.

James Marlay: Let's get down to a couple of specifics. John, I'm going to stay with you on this one. What's an example of a company that you think will thrive under an inflationary environment, and talk me a little bit through the thesis behind it.

John Lockton: One, we have is in the insurance space. So again, one that is a financial and is relatively cheap relative to history and on absolute PE is Insurance Australia Group (ASX: IAG). It's been in the sin bin for the last two years. It's been a COVID loser, yet, it's a good brand. And I don't know about you, but certainly on your personal insurance, whether it's your home or motor, you're seeing mid to high single-digit price increases come through. 

So it's a duopoly market, it's IAG or it's Suncorp. They do have pricing power. And it's not going to take a lot for inflation to be one of the potential tailwinds - not the only tailwind - but one of the potential tailwinds, which could help lift the share price on IAG quite materially.

James Marlay: Okay. IAG is John's example. Shane, what have you got that's an example of a company that thrives within this inflationary environment?

Shane Fitzgerald: We like the oil sector, similar to John, probably for the same reasons. The underlying economies are really booming at the moment. GDP growth rates have crossed everywhere. It's doing quite nicely at the moment. So the demand's there. The other thing that's also impacting the oil space is, because of ESG - legitimate ESG concerns and rationale, there's been such an underinvestment in new oil fields and new production techniques in the space that supply is going to be tight. 

We think the oil price could move materially higher from here.

James Marlay: All right, folks. Well, that was a few tips on how to diagnose how much inflation is going to impact your portfolio and a few sectors and stocks that might benefit as inflation takes hold in 2022.

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