Prices And Parallels To The Past – From The Desk June 2022

Headlines feature daily around the rising cost of fuel, electricity and commodity prices. Set against a backdrop of elevated geopolitical tensions and an urgent need for energy security. At the same time a tight labour market sparks worries of a wage-price spiral and broader fears of a hot and embedded inflation that will be difficult to cool. This is the situation that policymakers and investors alike faced in the 1970s, an era that is now synonymous in economics with “stagflation”. An era that bears eerily similar parallels to today and one that raises the question of how best to protect portfolios?

Of course, there are notable differences. The fashion for one (thankfully). Also, the energy crisis today is much more acute in Europe than elsewhere. The US now scrapes in as a very minor oil exporter versus its importer status of the ‘70s. Consumer and corporate balance sheets are also stronger. However, the lessons from the stagflation period are still very real in the minds of central bankers and they are likely to do whatever possible to ensure we do not repeat history and avoid being the next Arthur Burns! With this in mind, we view a stagflation replay as only a 15-20% chance.

The inflation situation in the US remains much hotter than at home, much like the weather of-late. However, we are catching up. Concerns of faster wage growth are growing (Chart 1), particularly following the minimum wage rate rise, which partly prompted RBA Governor Phil Lowe to quickly talk down the need for broader wage increases. Yet the reality is we face a tight labour market with a large gap between jobs and the workers needed for them.

The challenge of rising costs, whether labour or other inputs, will likely persist and contribute to higher headline inflation over the rest of the year. We have gone from a prolonged period of globalisation and cheap inputs to relatively scarce and expensive ones. As such input price gains far outstrip those of outputs (Chart 2).

In turn, we will likely see investor focus shift more from top line revenue growth to margin sustainability and their volatility. We have already seen the valuation gap between high margin and high growth narrow (Chart 3).

Those that can better manage through this period will likely be companies with strong pricing power. This is where the traditional defensives bucket becomes murky. To pass on costs effectively to buyers requires a good industry structure, differentiated products and defensive volumes. We think certain names in the healthcare space would tick these boxes. Resmed for example has a large underpenetrated market, and despite various input and logistics cost pressures, has been able to pass through price increases given their dominant market share and current lack of reputable competition. 

In infrastructure, Transurban for example has built-in price increases for its contracts. The nature of its cost structure brings high EBIT margins and margin stability. Anecdotally, you know the cost of tolls are rising when every second taxi driver makes a point or two about it.

While these are two examples we like, we should stress our views are supported by our fundamental insights, rather than the broader economic climate. Another lesson from the 70s is that the global macro picture does not trump company fundamentals. For example, both the US and UK faced a similar stagflation narrative. However, UK banks performed terribly amid a severe property price crunch, while their US peers outperformed.

Overall, a repeat of the 70s stagflation era is not our base case, however the parallels continue to grow. With them, we believe pricing power will help distinguish the truly defensive names, just as we can now distinguish some questionable and almost forgotten hair styles of the period.