Rising inflation and supply chain disruption are a key AGM theme this year. But ASX investors can find opportunity if they know where to look. Pendal equities analyst ANTHONY MORAN explains

• Inflation pressures the talk of AGM season
• Opportunity for some to rebuild margins
• “Classic early cycle” 

RISING INFLATION could deliver improved earnings for companies agile enough to rebuild margins and capacity in the face of higher costs, says Pendal equities analyst Anthony Moran.

Supply chain constraints, rising input and energy costs and scarce labour are driving inflation higher. US consumer prices are up 6.2 per cent year-on-year to October and Australian inflation is up 3 per cent in the year to September.

But beneath the scare stories on the news, this year’s Annual General Meeting season suggests that a bout of inflation could turn out to be a benefit for some ASX companies.

“We’ve all seen the headlines around inflation and supply chain issues and there has been a bit of anxiety around that,” says Moran.

“But through AGM season we are now starting to get a real read on how inflation is affecting companies.

“What’s interesting is that companies with pricing power can pass through this cost inflation — and for some, it’s even got to the point where they are getting a little margin expansion.

“Some companies are seeing this as an opportunity.”

Several themes are converging to create favourable outcomes for certain companies, Moran says.

For a start, the very fact that inflation is headline news is conditioning consumers for higher costs, which creates a favourable environment for companies to push through price rises.

But perhaps more importantly, consumer demand remains strong.

Household budgets are in good order. Government stimulus payments have allowed people to top up savings, rising house prices are lifting home equity and low interest rates are releasing disposable income.

Demand is particularly strong for construction materials like siding, bricks and plasterboard.

And amid the strong demand, supply constraints are hampering the ability of overseas companies to compete, allowing domestic manufacturers to regain market share while pushing through price rises.

Classic early cycle

“This is the classic early stage of the economic cycle where inflation isn’t a negative yet,” Moran says.

ASX investors should look at large companies with pricing power and domestic manufacturing capability. He nominates US-based home siding maker James Hardie and bricks and plasterboard maker CSR as examples of companies winning in the current cycle.

But watch out for companies that cannot pass on price rises. Moran points to Dominos as an example of a company finding it hard to lift prices when its marketing relies on the promise of cheap pizza.

“There will be losers from all this but at this stage we’re actually finding more winners than losers,” he says.

The rebuilding of capacity and pricing power also gives some clues to how the debate over whether inflation is transitory or here to stay will play out, says Moran.

“We are wearing sky high inflation and freight costs in all these industries — timber is up 50 per cent, steel is up similar.

“But the response from companies to this is to build more capacity.

“And as new capacity is added, prices for all of these commodities will come off again so you will get a steady deflationary pulse.”

Supply chain outlook

Investors should watch US immigration trends for clues on how the supply chain constraints will resolve, Moran says.

“The real silver bullet for many of these issues like freight will be international migration of workers resuming.

“The fundamental issue with freight is a lack of truck drivers. To get more drivers you need higher wages and you need more migration.”

As always, investors need to consider the risks.

As inflationary pressures unwind and commodity prices fall, companies that had been benefitting from higher prices will come under pressure. And as freight normalises, imports will become competitive again.

“These things that have been positive drivers may reverse,” says Moran.

The other risk is that inflation begins to crimp demand.

“If we see a demand slowdown but inflation persisting, then pricing power may evaporate and you actually end up in the worst of both worlds with rising costs and lower revenues.

“You’ve got to watch that cycle like a hawk.

“The good news is that it appears that global policymakers are solving for slightly higher inflation and slightly higher demand for longer to help the global economy recover from COVID disruptions.”

Hunger for earnings growth certainty is driving valuation of quality companies and infrastructure businesses as investors set up portfolios for the re-opening, says Pendal equities analyst Anthony Moran

• Pension funds are driving infrastructure prices to records
• Stay diversified, says analyst Anthony Moran
• Find out about Pendal Focus Australian Share Fund

“PEOPLE are seeking certainty in an uncertain world,” says Pendal Australian equities analyst Anthony Moran.

“We’re seeing people willing to pay bigger premiums than we’ve ever seen before for the certainty of strong earnings momentum or the multi-decade earnings certainty of infrastructure.”

The recent ASX company reporting season shows investors are willing to pay a premium for companies with good operating momentum.

They are betting a demonstrated ability to perform well amid the pandemic disruptions means a company will be able to power out of lockdowns and deliver strong growth over the coming 12 months, Moran says.

Rising input prices have been a feature of the pandemic. Supply constraints from manufacturing disruption and a shortage of freight capacity have paired with strong demand to drive prices higher.

“One of the implications for portfolio construction is to be aware of stocks that have measures in place to manage those risks or have pricing power,” says Moran.

He highlights building materials companies James Hardie Industries (ASX: JHX) and Fletcher Building (ASX: FBU) as particularly good examples. The momentum they took into the pandemic has served them well in coping during the disruptions, he says.

“For Hardie, it was about having availability of products when their competitors didn’t — and having a strong brand and having invested a lot in customer relationships.

“For Fletcher, they were kicked around for years by cheaper importers as they held on to being a domestic manufacturer. Now the shoe is on the other foot because of the supply interruptions hurting imports.”

These trends are likely to persist, Moran says. Companies with strong operating momentum will continue to perform well, since strong underlying demand will continue to buoy sales, he believes.

Search for stable, long-duration assets

The second big trend underpinning the market is the urgency with which big superannuation and pension funds are searching for stable, long-duration assets.

This is driving a flurry of takeovers in the infrastructure sector and pushing valuations to all-time highs. It’s led by multi-billion-dollar bids for companies such as Sydney Airport (ASX: SYD), Spark Infrastructure (ASX: SKI) and AusNet (ASX: AST).

“It’s fascinating because we’re seeing unlisted money willing to pay a materially lower cost of equity than the listed markets. They say they have a longer-term time frame. We would say they have got too much money trying to find a home.”

Moran says only particular types of companies are attractive to the big super funds: “It’s got to be long-dated, it’s got to be a hard asset and it’s got to be ESG [Environmental, Social and Governance] friendly.”

How can investors play these twin trends?

Moran says the key is to hold a diversified portfolio and not get too caught up in the interest-rate driven games played by institutional investors.

“It’s about recognising there are different kinds of opportunities and you can make money in all sorts of ways in any given market.

“You want to have a balanced approach. If all you have in a portfolio is these stocks, the moment you get a switch in the market momentum away from growth and quality towards value, that could whip against you extremely quickly.”

It’s not a theoretical concern. A sustained lift in inflation, higher GDP revisions and rising interest rates could all potentially shift the dominant market view, says Moran.

The answer is to find exposure to stocks where there is a chance that earnings momentum will pick up as lockdowns pass or where there are clear catalysts to close the valuation gap, he says.

Rate rises and inflation are impacting consumer behaviour — but there are opportunities if you know where to look, says Pendal’s SONDAL BENSAN

• Rates and inflation drive consumer change
• Household spending holding up for now
• Find out about Pendal Focus Australian Share Fund

YOU may have noticed it’s tough to buy a new suitcase at the moment — but there’s suddenly an oversupply of laptops.

Rapid changes in buying behaviour — exacerbated by rising rates and inflation — mean challenges for equity investors focused on ASX-listed consumer cyclicals.

But there are opportunities if you know where to look, says Sondal Bensan, an analyst with Pendal’s Aussie equities team.

Unusual confluence

Companies selling goods and services to households are facing the twin headwinds of rising inflation and higher interest rates — even as they adapt to the post-Covid reopening.

This unusual confluence of events is causing volatility in stock prices and making it tricky to predict how the sector will ride out the cycle, says Bensan.

“There’s a big shift going on — in revenue and in costs.

“We are seeing shifts in the mix of what people are spending money on, and there’s a huge pressure wave of costs coming through that’s hitting margins.”

The Covid years were characterised by increased spending on household-related activities like homewares, renovation and electronics. But as economies revert to normal, people have shifted their spending to out-of-home experiences.

“During Covid you could barely get hold of a laptop,” says Bensan. “Now it’s almost the opposite. Now retailers are running out of luggage and they are being stuck with stock in the categories that did well during the pandemic.”

The impact of the shift is that many consumer cyclical companies are reporting above-trend revenues even as the cycle turns because of the extra purchasing pulled forward by the pandemic.

“Some of the retailers’ revenues are 30 per cent above what they were pre-COVID. In a normal market, they might grow 8 or 9 per cent in a two-year period so they are way above trend,” he says.

“The dilemma for investors is that the next move may not be back to trend — it may be that because of the excesses you end up moving below trend.

“People that found themselves with two or three televisions during the pandemic won’t need to replace them for some time.”

Inflation impact

At the same time, companies are facing the headwind of rising inflation.

“You’ve got cost pressures across the board. Supply chain costs due to fuel, due to capacity constraints, due to domestic supply chain because people are off ill with Covid.

“You’ve had all these negative forces on supply chain costs coming through at the same time revenue could start to go below trend.”

And now households now face rising interest rates, with the Reserve Bank lifting the cash rate to 0.85 per cent on Tuesday, raising the prospect that household themselves could start to come under pressure.

“Every 50 basis points in interest rate rises is about 0.8 per cent off household income,” says Bensan.

“And then there’s inflation itself — food inflation, petrol prices, gas and electricity prices. These are big movements in prices for households and they clip incomes.

“An extra 1 per cent on the CPI means there’s 1 per cent less money for households to spend.”

Households holding up

So far, households are holding up well.

Bensan says the pandemic prompted people to save more than they used to: the household savings rate is up to 11 per cent of income from 4 or 5 per cent pre-Covid.

“And the other component is incomes. The last data showed household wages growth at 5 per cent which is above inflation and a net positive.”

“There’s heaps of buffer. That’s why so far even though you’ve had all these things happen, revenue for discretionary stocks is holding up — even for the ones that had benefited from COVID.”

Bensan says ultimately the direction of the cyclical stocks will depend on the trajectory of interest rates.

“Another 1 per cent on rates and you’d still be fine — households have enough buffer there.

“But if it goes beyond that — NZ is talking about mortgage rates getting to 6 per cent — than it could be challenging. That would be a big drag and eat up all the buffer that’s there.

“But on balance, there’s more pessimism than what the reality probably is right now.”

What it means for investors

Bensan says one path for investors is to find companies that took the opportunity through the COVID period to restructure their businesses and reduce their cost bases.

He points to Qantas and Nine Entertainment as examples.

“A lot of companies that look like they are doing well are just pulling revenue forward from future years. If anything, they will end up worse off than they were before,” he says.

“But some others who have used the COVID period to reform will actually end up far better off.”

He says companies with variable costs bases that can be adjusted down as revenues fall will be better off than those unable to reduce costs.

And companies with resilient, subscription-based revenues will be better placed to weather a downturn in household spending than traditional retailers.

“It’s not just the revenue falling, they have inventory as well. When you have excess inventory, you have to clear it and discounts affect margins.

“Those kind of stocks have probably got a lot more earnings risk ahead of them.”

Aussies have overseas holidays on their minds. But has Zoom impacted corporate travel for good? How will ASX travel stocks fare in 2022? Pendal analyst Sondal Bensan has some answers

• Leisure and corporate travel to bounce back
• Investors have under-priced some ASX travel stocks
• Find out about Pendal Focus Australian Share Fund

Will Zoom kill corporate travel? Or at least wound it?

This is arguably the biggest unknown for travel stocks in the post-Covid world, because corporate travellers are higher-yielding than leisure tourists.

“People had thought there would be a permanent loss of corporate travel demand because of video conferencing platforms like Zoom. But I think it will come back pretty strong with just a bit of a lag,” says Pendal Australian equities analyst Sondal Bensan.

“We always thought leisure would come back strong and business would be a bit of a drag. But it looks like there hasn’t been any permanent damage.

“Before Covid, demand for the sector was growing at a couple of per cent per annum. Now we’ve had two years of interruptions, but the post-Covid starting point should be a trend line above the previous level.

“That reflects both natural growth and a phenomenal wave of pent-up demand.”

A rebound in corporate travel has not been fully priced into some travel stocks, including Qantas, he says.

“The market is pricing in part of the revenue recovery but it’s not pricing in the margin outcome from that recovery.

“The profitability post-Covid from domestics and international travel could be significant. Investors have priced in domestic re-opening but not international.”

Bensan says margins will be higher both because of stronger-than-expected demand from corporate travel and also because airlines in particular have done a very good job at maintaining pricing, even during the pandemic.

“We’ve seen it in the US, New Zealand and here. That’s been a big surprise — the industry’s ability to manage prices.”

Some travel and tourism stocks tumbled when Covid hit, then experienced a massive adjustment period and emerged more efficient. Bensan expects some airlines, including Qantas, will do the same.

Factors to watch

No sector has been hit harder by the pandemic than travel and tourism.

But the best operators have been able to withstand the tumbling revenue and restructure. And as the economy heads towards a post-Covid phase, there are other kickers that will substantially help the sector.

Throughout the Covid period there has been glimpses of what might be for the sector.

“If you look at late last year and then the June quarter, the recovery in travel was quite remarkable. It ramped back up a lot quicker than many people thought.”

There are other factors helping travel and tourism stocks.

Many will have tax losses they can carry forward. Also working capital should benefit balance sheets in the short term, based on the experience of the industry during the June quarter, when travel and tourism re-opened ahead of the most recent lockdowns.

“There will be the initial surge in cash from people starting to make bookings again,” Bensan says, and he expects travellers will make plans further in advance, elongating the gap between payment and travel.  

“People’s attitudes will change. They will book in school holidays well in advance. Booking international travel will be longer duration that it ever used to be.”

In this podcast Pendal’s head of government bonds TIM HEXT explains what’s next for inflation, rate cuts and why this environment is favourable for active investors

You can also listen to this podcast on Apple or Spotify

An excerpt from this interview with Pendal’s head of government bond strategies Tim Hext:

As tariff news has died down, markets have come flying back in the last few months.

“But we do have a world now where the US tariff rate on average is around 18%,” observes Pendal’s head of government bonds Tim Hext.

“That is not a world we have seen for almost 100 years, not since World War II.”

It’s an environment made for active investors, says Tim in this new short podcast.

It can take years to understand the full impact of trade tariffs, yet markets tend to be very short-term focused, he says.

“That does present a lot of opportunities for an active manager,” says Tim.

“It gives does give us plenty of good opportunities to add value in active portfolios, and that’s what we’re doing at the moment.”

Listen to the full podcast above or learn more about Tim in his latest Pendal profile interview, as he explains why the case for bonds – and active management – has never been stronger.

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About Tim Hext and Pendal’s Income & Fixed Interest boutique

Tim Hext is a Pendal portfolio manager and head of government bond strategies in our Income and Fixed Interest team.

Tim has extensive experience in banking, financial markets and funding including senior positions with NSW Treasury Corporation (TCorp), Westpac Treasury, Commonwealth Bank of Australia, Deutsche Bank, Bain & Co and Swiss Bank Corporation.

Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.

Find out more about Pendal’s fixed interest strategies here

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About Pendal

Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management.

In 2023, Pendal became part of Perpetual Limited (ASX:PPT), bringing together two of Australia’s most respected active asset management brands to create a global leader in multi-boutique asset management with autonomous, world-class investment capabilities and a growing leadership position in ESG.

Contact a Pendal key account manager

In a new podcast, Pendal’s head of income strategies AMY XIE PATRICK explains the outlook for the world’s two biggest economies and what it means for investors

You can also listen to this podcast on Apple or Spotify

An excerpt from this podcast

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Amy Xie Patrick, Pendal’s head of income strategies:

After two days of talks in London, China and the US last week agreed in principle to de-escalate trade tensions.

What happens next is unclear.

But in a new podcast, Pendal’s head of income strategies Amy Xie Patrick explains the outlook for the world’s two biggest economies and what it means for investors.

China is “in a period of healing, but I do see some green shoots”, says Amy. “Property market statistics are generally stabilising.”

But the “ultimate bright spot for the Chinese economy” is its credit impulse – a measure of the change in new credit issued as a percentage of GDP, Amy says.

“It’s still a very credit-thirsty economy. And if the credit impulse of the economy as a whole is starting to stabilise and trend upwards, which is exactly what we see in the data, then that generally bodes well for the overall economic direction. “

On the US, Amy says the “sheer resilience” of its economy through the trade uncertainty incredibly surprising to the market.

Despite sentiment indicators “down in the dumps”, US economic data is not showing significant weakness yet.

For investors, “the better risk-reward in terms of chasing a bit of upside exposure in portfolios is the safe accrual plays in credit rather than say, chasing after equity markets this close to the all time highs.”

Australia is in a surprisingly good position to weather the Trump administration’s trade policies, says Pendal’s head of government bonds TIM HEXT in this fast podcast

You can also listen to this podcast on Apple or Spotify

An excerpt from this interview with Pendal’s head of government bond strategies Tim Hext:

An excerpt from this interview with Pendal’s head of government bond strategies Tim Hext:

Australia is in a surprisingly good position to weather the Trump administration’s global storm, believes Pendal’s head of government bonds, Tim Hext.

“We have reasons to be optimistic down here, albeit it’s not going to be quite as good as it could have been.

“We’re going to get very close to all our long-term aspirations this year.

Inflation is expected to end the year around 2.7% – within a whisker of the 2.5% target. (Read Tim’s take on the latest inflation data here).

Growth is likely to be around 2.25%, unemployment around 4.25% and wages around 3% to 3.25%, he says.

“The trouble of course is what Trump and his tariffs may do to that – but I still think we can be reasonably confident Australia will weather the upcoming storm well.

On rates, Tim sees the RBA “gradually coming around to that view that full employment is around about where we are now”. That likely means at least three more rate cuts this year.

“Clearly if you were to get global concerns really feeding through, we might see a lower path, but I think the base path is around to about 3.35% cash rates.

So in a sense, you’d have all the data and the cash rates pretty much on what most people would consider to be averages through the cycle.

Not a bad spot to be in.

Listen to the full podcast above or learn more about Tim in his latest Pendal profile interview, as he explains why the case for bonds – and active management – has never been stronger.

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About Tim Hext and Pendal’s Income & Fixed Interest boutique

Tim Hext is a Pendal portfolio manager and head of government bond strategies in our Income and Fixed Interest team.

Tim has extensive experience in banking, financial markets and funding including senior positions with NSW Treasury Corporation (TCorp), Westpac Treasury, Commonwealth Bank of Australia, Deutsche Bank, Bain & Co and Swiss Bank Corporation.

Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.

Find out more about Pendal’s fixed interest strategies here

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About Pendal

Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management.

In 2023, Pendal became part of Perpetual Limited (ASX:PPT), bringing together two of Australia’s most respected active asset management brands to create a global leader in multi-boutique asset management with autonomous, world-class investment capabilities and a growing leadership position in ESG.

Contact a Pendal key account manager

In this video profile, Pendal’s head of government bond strategies TIM HEXT explains why the case for bonds – and active management – has never been stronger

An excerpt from Tim’s interview

In this video, Tim Hext – head of government bond strategies at Pendal – shares insights drawn from a 30-year career spanning trading desks, bank balance sheets and state government funding.

His deep understanding of both the macro conditions and inner workings of bond markets have helped shape the strategy behind the Pendal Government Bond Fund.

Tim explains how Pendal’s active management approach can help capture value beyond the macroeconomic view, through the skillful selection of securities from across the government bond universe.

“Even in volatile conditions, government bonds give investors the flexibility to respond – to rebalance, or to lean into opportunity,” he says.

“We position for where the economy is going – not where it’s been – and we go deep on security selection. Knowing how different states fund and price their debt helps us capture opportunities others miss.”

Watch the video to learn more about Tim and Pendal’s active approach to fixed-income investing.

Get to know the rest of the team better in these individual profile videos:

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About Tim Hext and Pendal’s Income & Fixed Interest boutique

Tim Hext is a Pendal portfolio manager and head of government bond strategies in our Income and Fixed Interest team.

Tim has extensive experience in banking, financial markets and funding including senior positions with NSW Treasury Corporation (TCorp), Westpac Treasury, Commonwealth Bank of Australia, Deutsche Bank, Bain & Co and Swiss Bank Corporation.

Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.

Find out more about Pendal’s fixed interest strategies here

---

About Pendal

Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management.

In 2023, Pendal became part of Perpetual Limited (ASX:PPT), bringing together two of Australia’s most respected active asset management brands to create a global leader in multi-boutique asset management with autonomous, world-class investment capabilities and a growing leadership position in ESG.

Contact a Pendal key account manager

In this video profile, Pendal PM George Bishay explains the advantages of our Income and Fixed Interest team’s process

An excerpt from George’s interview

WHILE fixed income forms the defensive part of a diversified portfolio, offering investors a lower degree of volatility relative to equities, it still requires skill and experience to navigate through the market cycle.

Pendal’s Income and Fixed Interest team benefits from the diverse experience of its four lead portfolio managers, says head of credit and sustainable strategies George Bishay.

“If you think about the four lead portfolio managers, the average experience is 28 years per person,” he says. “The other important aspect of our team is they’re all experts in their own field across the sub-sectors within fixed income, whether that’s credit, government bonds or cash.”

In this video, Bishay — who has spent more than three decades working in credit, analysis and portfolio management roles — explains how Pendal’s investment process is a “real differentiating factor relative to our peer group”.

“A big differentiator to the way we manage money is our top-down process and our active de-risking and re-risking of our portfolios based on our process,” he says. “That unique top-down process combines our qualitative views and quantitative models with technical analysis.”

Watch the full video to learn more about George and the investment process of Pendal’s Income and Fixed Interest team.

Get to know our portfolio managers better in these individual profile videos: