Stick to businesses with strong pricing power in a high inflation scenario

Invest in commodity producers that are backward integrated

When inflation rose initially, central banks dismissed it as transient. Now, however, it has become entrenched globally. Retail investors need to watch out for this risk as it could impact their stock portfolios.

Supply disruptions driving inflation   

Consumer price index (CPI) based inflation rose to a five-month high of 5.59 per cent year-on-year in December. It is still within the 2-6 per cent range that the Reserve Bank of India targets. In the United States (US), it touched a 40-year high of 7 per cent in December.

Covid-19 restrictions and lockdowns have led to production disruptions and created shortages. “Transportation bottlenecks, including container shortages, have compounded supply shortages,” says Mrinal Singh, chief executive officer and chief investment officer, InCred Asset Management Company.  

Direct fiscal transfers into peoples’ hands, especially in the US, have led to strong demand. Global liquidity, according to Singh, has also been deployed on the speculative side.   

Commodities are a prime contributor. “There was a downturn in commodities for 10-12 years and then demand bounced back from the pandemic lows,” says Sujan Hajra, chief economist and executive director, Anand Rathi Shares and Stock Brokers.

Many commodity segments are witnessing demand-supply mismatch. “Wh­en energy prices fell, the weaker natural gas players in the US became bankrupt. Now, when demand is back, supply is not available to meet it,” says Rajeev Thakkar, chief investment officer, PPFAS Mutual Fund.

Growing environmental concerns have led to production cutbacks for many commodities in China.

Crude prices are up due to several factors. “Geopolitical issues between Russia and Ukraine, high winter demand, and the Organization of Petroleum Exporting Countries (OPEC) not increasing production in line with demand have led to the current spike,” says Siddhartha Khemka, head of retail research, Motilal Oswal Financial Services.

Prices of most commodities have eased from their peaks in recent times.  

High, but manageable

Hajra expects inflation to stay in the 5-6 per cent range this year, averaging around 5.5 per cent. According to Thakkar, “Inflation caused by supply-side constraints may ease in a few months as more production comes online. But demand produced by high liquidity could keep prices elevated in many areas for some time.”  

Commodity inflation may not ease soon. “Lower demand from a slowing China will be countered by higher demand from countries like the US and India which are undertaking infrastructure development,” says Hajra.     

Risky above a tipping point

If inflation is moderately high, amid strong demand, corporates are able to pass on cost increases (input cost to sales ratio is about 50 per cent for India’s manufacturing sector) and continue to do well. The tipping point, according to Hajra, is 8 per cent. Once inflation crosses that level, it causes demand destruction and begins to affect corporates adversely.

Who will thrive  

Some companies tend to be resilient in a high-inflation environment. “Companies with strong pricing power, which can pass on input price increases to consumers, weather inflationary conditions well. Those with weak pricing power struggle as their margins come under pressure,” says Thakkar.

Primary commodity producers also benefit. “Those that are backward integrated benefit because they have control over their raw-material supplies,” says Singh.

Gaurav Dua, head-capital market strategy, Sharekhan by BNP Paribas expects mining, oil exploration, and metal firms to outperform if high inflation expectations build up globally.

Banks with strong current account and savings account franchises will do well. As interest rates move up, their margins will improve.

The information technology (IT) sector, which is immune to rising raw material prices, may not be impacted. Sectors like pharma and healthcare, which can pass on price increases, are also likely to do well. Rupee depreciation in an inflationary environment will be positive for exporters like IT and pharma.

Who will suffer

Users of metals and crude derivatives, like auto, consumer durables, and paint companies will be affected by rising input costs. If interest rates move up, leveraged businesses will be hit by higher interest costs (unless rate hikes lag inflation, and their real interest costs decline).   

Consumer staples players, too, could be affected. According to Dua, “Consumer demand is not very strong currently due to the skewed economic recovery. Rural demand has been slack. Consumer companies are finding it tough to pass on input cost pressures entirely without adversely impacting volume offtake.” At high levels of inflation, consumers down trade and that affects the revenues of these companies.  

Consumer durables companies may find the going difficult. “It is a highly competitive, price-sensitive segment where players struggle to protect market share and margins,” says Thakkar. Singh adds that these companies could be impacted by buyers deferring purchases in a high-inflation environment.   

What you should do

Equity is the asset best placed to offer inflation-beating returns over the long term, so keep investing in it in a staggered manner. But exit low return on capital or loss-making businesses commanding high valuations currently and reorient your portfolio towards higher-quality businesses.

Be watchful if you invest in commodity stocks. “Invest if you understand the commodity cycle and can exit before it turns,” says Khemka.