Analyses
Credit Markets Brace for Inflation: Winners vs. Losers
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Insight Article
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novembre 15, 2021
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Credit Markets Brace for Inflation: Winners vs. Losers
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novembre 15, 2021
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Credit Markets Brace for Inflation: Winners vs. Losers
Credit Markets Brace for Inflation: Winners vs. Losers |
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With U.S. inflation accelerating to its highest rate in a decade, near-term uncertainties related to the pace of interest rate hikes and the impact on earnings are top of mind for many credit investors.
Based on underlying sector trends, we see this current period of accelerating inflation as part of an economic expansionary phase that could lead to a more sustained global recovery and GDP growth over time. When we look at the effects of inflation on credit profiles by sector, we can examine the impact of wage inflation as well as higher commodity and input costs on the earnings and cash flow trajectory.
Undoubtedly, the supply shock created by the pandemic has led to higher prices. Across industries, supply-chain disruptions and longer-term strategic shifts to bring manufacturing onshore have strained resources, causing input prices to rise. We believe these are durable factors that can exert upward pricing pressure and drive so-called cost-push inflation.
But this is more than just a supply shock. We also observe a substantial recovery in demand across sectors. Importantly, we expect that to grow for a variety of reasons, consistent with an economic expansion. That can also exert upward price pressures, so-called demand-pull inflation.
Source: Morgan Stanley, as of September 30, 2021.
Source: Morgan Stanley, as of September 30, 2021.
First the good news: Sectors with a chance to win
- Inflation is broadly positive for Banks based on the prospect of higher rates. While Banks face some wage inflation and cost pressure, their record deposits and low defaults suggest that any impact on earnings would be more of an equity story. It’s important to note that rate hikes may not automatically translate to a tightening in monetary conditions, since a true tightening only occurs when the real policy rate exceeds the neutral policy rate.
- In the U.S., the real policy rate could remain negative and below the neutral policy rate over the next few years. We base this assessment on the Federal Reserve’s Summary of Economic Projections from September, with the real policy rate projected to be negative at -0.35% — calculated as the Fed’s 2024 median projected nominal policy rate of 1.75% minus projected inflation of 2.1% — versus the estimated neutral rate of 0%.
- All else equal, therefore, we believe the aggregate impact of higher rates on Banks’ credit profile may be positive at least through 2024.
- Elsewhere in the sector, Insurers can pass through some higher labor and commodity costs in higher premiums for consumers, subject to regulatory caps. REITs generally have inflation-linked rent escalators that are pass-through in nature, leaving their credit profile unchanged.
- In Industrials, pockets of cost-push inflation may tilt earnings to the negative. However, green shoots of demand-pull inflation, coupled with rational behavior among producers, would be broadly supportive of the credit profile.
- Demand is healthy, bolstered by the macro trends of accelerated digital transformation and a sustained focus on increasing productivity.
- Semiconductors in particular exhibit strong growth across key end markets, including Computing, Wireless, Industrials and Consumer, and we expect double-digit growth from Automotive specifically. From an ESG standpoint, Semiconductors are essential to improving the efficiency of end products and enabling the transition from analog to digital interfaces. Therefore, higher Semiconductor prices are likely to persist without comprising growth. We think chip manufacturers will continue to enjoy significant pricing power as long as demand outpaces supply.
- Energy is another sector with positive momentum. The United States is one of the world’s largest oil producers and has been disciplined on adding supply lately, though not always historically. At present, U.S. producers are unlikely to flood the market even in an inflationary environment for a variety of reasons, including supply chain issues and labor shortages in Oil Field Services. Rising energy prices generally lead to improving cash flow for the producers.
- Pipelines still have substantial capacity to meet incremental demand. Midstream assets typically have pass-through triggers in contracts that are effectively dealing with COVID-related supply chain and inflationary pressures.
- There are some regional differences to highlight for this sector. Natural Gas prices are up 200% to 300% year to date in Europe and Asia, mostly spiking in the past three months, compared to 125% in the U.S.1 As a fallout of these differences, we will likely see curtailments of Agricultural Chemicals in Europe, whereas U.S.- based producers are seeing tailwinds from price expansion.
- Government intervention in Europe — aimed at controlling supply and production while alleviating the impact for consumers on fixed incomes — is a headwind for corporates. For example, Spain has already increased taxes and directed Utilities to pass earnings toconsumers, which is another negative for the sector credit profile.
- Derivative products in Specialty Chemicals and Packaging, where pricing power is more limited, should nonetheless see long-term positives from higher prices, but there could be a two to three quarter lag of significant margin pressure.
- We expect metals to see positive inflationary effects, as end demand is strong and the sector benefits from pricing power. A caveat is that China’s Evergrande poses potential spillover risk for Steel and Iron Ore demand. Global underinvestment in infrastructure for commodities has been significant for a long time, so any pickup in demand could easily create supply shortages and drive up prices quickly. These are all supportive trends for earnings, cash flow and the overall credit profile.
- Higher inflation has boosted top lines among Automakers despite the lagging effect of higher commodity costs — for example, steel prices are often locked in several quarters in advance. We see signs of inflation most acutely in Used Vehicles, where prices continue to march higher, benefiting companies’ finance income. While the semiconductor chip shortage weighs on OEMs, the overall trend is improving. Notably semiconductor chips currently make up less than 5% of costs for EVs, compared to more than 40% for Mobile Phones and Solar.Automakers see better revenue and margins from higher new vehicle prices and the strong price and product mix, aided by factors including fiscal stimulus and accommodating monetary policy, in conjunction with the reopening of the economy.
Not all the news is positive: Sectors under pressure
- Consumers may see a net negative impact from inflationary trends, although wage growth and high personal saving rates may help to offset this, at least in part.
- Consumer Products, as a whole, face headwinds from commodity inflation in the low single digits. If not addressed by existing hedging strategies, most of this can be expected to pass through to consumers directly in the form of higher finished goods prices.
- Retailers will seek to protect already thin margins and continue to pass additional costs to consumers. Reopening post-COVID has led to labor shortages, requiring somewhat higher salaries and wages to entice workers back. Teenagers are filling some of the jobs, however, which is keeping a lid on wages relative to other industries.
- Gaming, Leisure and Lodging are broadly correlated with consumer spending. We expect pent-up demand from reopening and unspent stimulus dollars, which should at least partially offset the negative impact of higher food, rent, service and energy costs on purchasing power.
- Utilities have regulatory protections to offset rising costs. For example, higher fuel costs can be passed to consumers through fuel and purchased power adjustment clauses, outside of a general rate case. While rising operation and maintenance costs unrelated to fuel could impact the overall bottom line, expectations are for utilities to continue their cost-cutting measures and file more frequent rate cases to offset these.
- Defense and Transports have fixed contracts, which are thus exposed to higher costs on existing commitments that may also have long lead times — posing a risk that is a potential negative for both earnings and cash flow.
- In Diversified Industrials, higher raw material, packaging and logistics costs continue to pressure margins and eat into the savings that some companies realized during the pandemic.
- Among Consumer Non-Cyclicals, we are watching out for legislative scrutiny of the practice of increasing drug list prices. Any forthcoming action could negatively affect the long-term pricing power of Pharmaceuticals.
- Healthcare has been contending with deflationary pressures, given scrutiny over rising costs as a percentage of GDP and the ongoing transition to value-based care.
- Telecom and Media face a similar neutral theme, where competition will likely continue to keep prices lower, but we expect limited impact on earnings, cash flow and credit profile for this cohort.
Challenges and Opportunities Remain
As always, changes in the macroeconomic environment present both challenges and opportunities. Today, the big change is inflation and how companies adjust to this risk.
The elements of cost-push inflation that exist today may cause stress in some corporate sectors. Companies whose earnings, cash flows and profits are tied to factors that are fixed — and where both rising input costs and the inability to pass through high prices can squeeze margins — will face challenges.
On the other hand, there are companies that can address rising demand more efficiently, adjust prices more quickly, pass through higher costs and increase productivity. They may observe benefits to their earnings, cash flow and profit margins.
The opportunities lie in selecting sectors, and more specifically companies, that are best able to adjust, adapt and innovate during a changing environment.
Risk Considerations
Diversification neither assures a profit nor guarantees against loss in a declining market.
There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in a portfolio. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Certain U.S. government securities purchased by the strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. High-yield securities (junk bonds) are lower-rated securities that may have a higher degree of credit and liquidity risk. Sovereign debt securities are subject to default risk. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default, and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. The currency market is highly volatile. Prices in these markets are influenced by, among other things, changing supply and demand for a particular currency; trade; fiscal, money and domestic or foreign exchange control programs and policies; and changes in domestic and foreign interest rates. Investments in foreign markets entail special risks such as currency, political, economic and market risks. The risks of investing in emerging market countries are greater than the risks generally associated with foreign investments. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, and correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Due to the possibility that prepayments will alter the cash flows on collateralized mortgage obligations (CMOs), it is not possible to determine in advance their final maturity date or average life. In addition, if the collateral securing the CMOs or any third-party guarantees are insufficient to make payments, the portfolio could sustain a loss.
| INVESTMENT GRADE CREDIT RESEARCH TEAM |