After the first Covid-19 lockdown in 2020, there was a massive economic resurgence and prices took off. Markets recovered and many businesses experienced strong growth prior to the recent lockdowns on both sides of the Tasman.
Fast-forward 18 months and there is a widely held view that it will happen again, as vaccination rates rise and full-scale lockdowns likely become a thing of the past.
In our view, the assumption that 2022 will start with a boom and our recovery will be strong is not so clear-cut. Without the tailwinds of cuts to interest rates and government stimulus, fundamentals like cost of capital, margins and pricing power are increasingly important again.
Throughout the pandemic, annual inflation rates have been sitting at their highest level in more than a decade — driven by global supply chain pressures, energy and labour shortages, as well as strong consumer demand for goods. We don't see this halting the recovery, but it may not be as strong or as swift as predicted.
The reserve banks of New Zealand and Australia are moving their forecasts by 70-80 basis points, aligned with a growing number of central banks reducing monetary stimulus globally. While some of these inflationary drivers might be short-lived, others will be with us for the foreseeable future.
Investors should be watching this closely, as the stimulatory monetary policy that has supported economies through the pandemic has eased. They'll need to consider how to navigate an inflationary environment as they position their portfolios for the year ahead.
1. Inflation's impact will not be equal
Companies' ability to raise prices to offset increasing costs will become more important. We expect pricing power to play a larger role for companies looking to generate above-market earnings growth in 2022, because the ability to pass on higher prices (even if they are just inflationary) without losing business to a competitor, means profits are more likely.
For example, the telecommunications and electricity sectors are reliant on tangible assets such as lines and generation sites. The cost to build and maintain these will go up, with little opportunity to pass those costs on to consumers.
Big consumer technology businesses, or supermarkets, are more easily able to raise prices. Agri/horticulture stocks will also probably find this favourable because the cost of their products — fruit, vegetables, dairy, meat — will go up. Other beneficiaries of rising interest rates will include insurers, which will earn higher returns on investment portfolios that are weighted towards bonds.
On the other hand, businesses constrained by supply chain pressures have experienced significant price inflation recently. These include those reliant on commodities such as oil and batteries, as well as grains, cocoa and coffee. However, we are expecting a "supply response" as factories re-open and freight begins to normalise. This should help balance out the level of demand these businesses are experiencing.
The more at-risk category may also include some of the tech giants, which have been beneficiaries through Covid-19. To justify their current lofty valuations, they will need to prove they have pricing power not only at the revenue line, but equally at the wage line.
The inflation cost of human capital in digital has been extreme: good people are expensive and great people hard to find. The scalability of these tech companies' platforms will come into question as revenue growth slows from a higher base and the costs to serve their customers increase.
New Zealand has been leading from the front on interest rate rises, and a little bit ahead of Australia in acting on pricing, so there's some precedent and a roadmap for how things might pan out.
At the end of the day, we should expect the same issues to apply on both sides of the ditch and globally — it might just be timed differently.
2. Strong merger and acquisition activity continues, but inflation will change the game
Global M&A activity hit an all-time high in the first six months of 2021, with deals worth more than US$2.6 trillion. Factors influencing the strong deal momentum include a backlog of transactions, low cost of capital, record amounts of private capital, distressed companies, and improving confidence levels. These are anticipated to carry into 2022. That M&A activity has been strongest in the sectors least affected by Covid.
The inflationary environment will fundamentally change M&A as wage increases begin to balance out most price rises. Businesses set to benefit will be those merging with, or acquiring, companies that minimise their costs to make products or provide services, versus those simply focusing on the revenue line.
With rising interest rates, we've seen a lot of activity around securing infrastructure assets — and the appetite for this may change. Corporates are going to focus more on the cost of capital. Listed corporates have been slow to move because they've been focusing on this cost. They are facing competition from private equity and sovereign/state-owned investment funds and this pressure may increase as their borrowing costs rise.
3. The growing cost of carbon footprints
As governments focus their recovery plans on the immediate health and infrastructure issues regarding Covid-19, researchers carrying out this year's Global Carbon Budget analysis say they expect emissions to rise by 4.9 per cent in 2021. This is after we saw a drop in 2020 following widespread lockdowns.
Although the projected 2021 level is 0.8 per cent below 2019 rates, and many countries are taking positive steps, some are fast-tracking as many coal-based power or carbon-intensive projects as possible in the short term to get things moving again. This is moving away from what was discussed at COP26 in terms of carbon-reduction targets.
The response we've seen post-Covid will probably accelerate the price of carbon, which is currently sitting around $68 for New Zealand and A$41 in Australia. Some projections have this price, and the associated expense for emitting businesses, doubling by 2030.
4. There's a vaccine pass, but every business will need a social licence too
Covid-19 has certainly accelerated structural change. From an environmental, social and governance perspective, it will be interesting to watch how businesses approach flexible work arrangements and working from home — it's now something to be encouraged and businesses will have to adapt.
When the same job can be done from Los Angeles, Sydney, or Auckland, global talent also becomes more relevant. If adaptable, some companies based in New Zealand and Australia will now be able operate 24/7 because they will have people around the world.
Over the past 18 months, retail investors have also created a new pool of capital for businesses to think about in terms of funding, in the same way that exchange traded funds are a different portion of the market today. The rise of retail investors is not a new conversation, but the question is how big that pool really is. We're not sure but it's certainly not going to zero again.
There have been some interesting stats on the number of people who use apps to trade stocks or cryptocurrencies; the wealth created through these platforms is significant. Alongside earnings and revenue, the value of a brand is now an established factor that matters materially around the world.
This is not just in terms of brand recognition, but what a company stands for, its reputation, and how people identify with it. Businesses will need to consider how to pitch and resonate in that mix. A survey we ran in Australia found 56 per cent of consumers would be more likely to shop with a brand if it aligned with their values.
Companies that embrace social license can build greater customer and employee loyalty, which can ultimately drive higher returns and a strong brand. This is about a company being accepted and respected by its stakeholders — employees, shareholders and customers. It's looking at how they approach social change and follow through for their stakeholders.
The pandemic has affected all of us to varying degrees, and its impact has been wide reaching. While we should be hopeful about the path out of it, we should also be aware of the biggest lesson that we've learned through this period: the themes of uncertainty and change are here to stay.
Fiscal stimulus by central banks helped protect us from the pandemic's worst economic shocks. While investors watch closely as these economic boosts are phased out, we should be looking forward with optimism at a changed world that is continuing to evolve at a rapid pace.
- James Lee is managing director and chief executive officer, and Ben Gilbert is managing director, head of research, Australia, at investment and advisory group Jarden.