Which sectors could benefit as inflation heats up?

We wrote last year about our expectation that inflation would soon start to re-emerge in Europe, and that banks were likely to be among the chief beneficiaries.

This scenario has indeed come to pass, perhaps even more quickly than we had anticipated. With signs of inflation becoming ever more apparent, which other sectors should investors now be considering?

Inflation becoming embedded

The latest data put UK inflation at 1.8% in January 2017, close to the Bank of England’s target of 2.0%. Eurozone inflation for January is also estimated at 1.8%. The global economic cycle looks to be enjoying a synchronised pick-up that is feeding through into positive earnings momentum, particularly in the eurozone.

Furthermore, there is evidence that this pick-up in inflation is becoming embedded and is not just the commodity-driven spike that many commentators expect. As evidence of this, we note that recently companies from a broad range of industries (e.g. tyres, food and cement) have been talking about increasing prices to end customers in order to protect earnings.

This is not just a European phenomenon either; Chinese producer price index (PPI) inflation is positive for the first time since 2012 and wage inflation continues to pressure profit margins, keeping pricing front and centre of management minds.

Time to dial up telcos

The telecommunications sector is one we feel should now be the chief beneficiary of inflation. The sector was out of favour in 2016 and was the worst performer in the European market as investors mistakenly conflated telcos with bond proxies1. As a result, valuations are inexpensive and the sector is far from being over-owned.

After a period of intense competition between telco operators, we are now seeing ongoing market repair in many European countries. This is taking place with tacit government and regulatory acceptance, as incumbents need to invest in fibre and 5G mobile networks. Crucially, we think this investment in fibre and 5G will be adequately remunerated.

Opportunity in banks has diminished

Signs that inflation is coming back are fantastic for financials. Bank share prices have already seen significant gains in the latter half of 2016. Following this period of strong performance, we feel that the outsized valuation opportunity in banks has diminished, although there is certainly still scope for substantial profit improvements.

Within financials generally we particularly like insurance stocks. Insurers remain decent value and are less volatile than banks. They are also a clear reflation2 beneficiary, as this enables them to invest their income into bonds at higher yields.

Wage inflation benefits consumer stocks

Certain consumer stocks could also be among the gainers from the current reflationary environment. A classic business cycle investing approach would be to avoid consumer cyclical3 stocks while commodity prices and bond yields are rising.

However, that may not be the best approach right now given their underperformance already and with bond yields likely to remain low for now, albeit rising from the ludicrous current levels.

Indeed, while the interest rate hiking cycle in the US has started, it is proceeding slowly and other central banks seem to be deliberately behind the curve with regards to inflation.

At the same time, labour markets are tightening, so we could have a case of higher inflation due as much to higher wages as anything else. This would be a favourable environment for the consumer. We also note that many consumer stocks – such as auto parts suppliers and retailers – look cheaply valued on current earnings estimates.

In short, our view is that investors need to be looking for the value opportunities in Europe right now. We feel many higher quality parts of the market, which have been valued highly on the back of low interest rates, could continue to see their share prices struggle.

Sectors mentioned are for illustrative purposes only and not a recommendation to buy or sell.

1. Bond proxies are equities that are presumed to resemble bonds in terms of their ability to provide low-risk income, but with higher yields. Consumer staples or utilities stocks are examples.

2. Reflation is a fiscal or monetary policy designed to expand a country's output, seeking to bring the economy back up to the long-term trend after periods of stagnation or contraction.

3. Cyclicals are stocks whose share prices are directly related to the economic or business cycle.

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