Think inflation’s behind us? Think again – it’s only now that the corrosive effects of rising prices start to impact investment portfolios. SEAN ROGER explains how to combat the risk.
- Headline inflation declining, but earnings effect lingers
- Wage costs, rents rising
- Find out more about Perpetual’s Aussie share funds
THE lingering effect of inflation on wages, rent costs, and debt servicing will be a key drag on the performance of Australian shares over the next 12 months, says Perpetual’s Sean Roger.
Despite the headline consumer price index showing signs of returning to the Reserve Bank of Australia’s target band, the flow-on effects of rising prices are starting to show up in corporate earnings.
Higher wages, increased lease costs, and rising interest bills are putting pressure on corporate costs just as consumers wind back spending as the effects of higher rates squeeze household budgets.
“We’re seeing a softer demand environment and some increased competition starting to step up at the same time as corporate cost bases continue to rise,” says Roger, a portfolio manager with Perpetual’s Australian equity team.
“The result is margin pressure and downgrades.
“There’s a risk that this is a theme we continue to see for the next six to twelve months.”
Retailers under pressure
The country’s largest supermarket owner, Woolworths, told shareholders last month that earnings would decline compared to last year, in an investor update that triggered a sharp sell-off in its shares.
Rival Coles Group says it is seeing price deflation across product lines while Super Retail Group, which owns Rebel, BCF and Supercheap Auto, says it is lifting discounts to drive sales and has guided shareholders to expect rising costs.
Roger says the combination of higher costs and weaker sales poses an important risk to investors over coming months.
“The dynamic emerging in some of the quarterly reporting is that while headline inflation is coming down, there’s still a lot of pressure coming through on certain cost lines for companies,” he says.
“Wage pressure is the big one – the Fair Work Commission has increased the minimum wage 3.75 per cent for FY25 and negotiated enterprise wage deals are all seeing large increases.
“Rents are also rising – many companies have leases linked to CPI that are coming in with a lag. Interest costs are also a headwind, particularly for those companies that are rolling off fixed rate debt and/or hedges at lower rates”.
“The combination of those cost pressures are coming at the same time revenue is under pressure from consumers winding back their discretionary spending. This creates an environment where the risk of margin and earnings pressure is heightened”
Private label
Roger says he’s seeing increasing evidence of shoppers switching their purchasing away from branded products to lower cost home brand and private label options as well as reducing spending at mainstream supermarkets like Woolworths and Coles and moving instead to discount retailers like Aldi and Chemist Warehouse.
Wesfarmers, which owns Officeworks, Kmart and Bunnings, reports that customers are seeking value by buying fewer items at lower prices.
Increased competitive pressure is driving price deflation at the top line for supermarkets just as their costs are lifting.
Inflation lag
Roger says investors typically experience inflation in their portfolios in two main waves through an economic cycle – initially when the first inflation shock hits commodity and raw materials prices and then again in a delayed effect as wages and rents catch up to rising prices.
“Companies generally have two big buckets of cost – the cost of goods and raw materials, and the cost of doing business, which is typically led by wages and rents,” he says.
“The cost of doing business is the one that can often be lagged.
“We’re now in the point at the cycle where people are talking about inflation easing, but those lagged costs are still on the way up. That’s where you get the squeeze.”
The lag effect is why many companies enjoyed a period of rising margins during the early part of the inflation cycle as they were able to lift prices without their cost of doing business also rising.
“They had quite a nice period there they were putting prices up but the cost of doing business wasn’t moving. Now, the top line has started to flatten out, and then you’ve got the lag impact of costs coming through.”
What to watch for
So how can investors protect their portfolios against the squeeze?
Roger says it pays to be cautious in this environment because the affected companies are the ones that traditionally bring stable earnings and steady share price performance to a portfolio.
“These are not companies with volatile earnings – they are typically steady, stable growers, but they’re now susceptible to decent share price reactions if these themes sort of play through.
“It is a theme that is top of mind for us.”
Roger says one key to navigating the next period is understanding exactly what underpins a company’s cost base.
“What percentage of costs is exposed to wages? What is the exposure to lease costs? If they were to refinance their entire debt facility today, are they at the market, or have they still got a headwind?”
Second, he says take a close look at what’s driving each company’s top line sales.
“Do they have pricing power and the ability to pass costs on? If they don’t, they’re at risk of that top line coming under pressure.”
Finally, check up on the quality of the management team.
“High quality managers who have proven over time that they can act quickly and make decisive decisions to manage against these sorts of shocks can give you a layer of protection.”
Momentum a factor
Roger says earnings forecasts are the key driver of share prices in the current environment, overriding traditional valuation metrics.
“The momentum factor is strong – we’ve seen tech share prices rising irrespective of valuation after slightly beating earnings expectations. And on the other side, even undervalued stocks are selling off after negative surprises.”
He points to a Flight Centre trading update last month that sent the share price falling 25 per cent despite market analysts trimming estimates by just 10 per cent.
“It can change quickly, but essentially the driving force behind share prices right now is market expectations of earnings for the next 12 months.”
Sean Roger is a portfolio manager with Perpetual’s Aussie equities team.
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