Investment insights from BlackRock Fundamental Equities

How equity investors can navigate the inflation dilemma

Inflation – it’s expected but, in our view, not imminent.  While any short-term spikes are likely to be temporary, investors should be aware of early inflationary signals, as well as opportunities to capitalize on those companies with the ability to pass on rising costs. We believe active selection is key in this shifting price environment.

  • Companies that can pass rising costs on to customers could see a share-price boost.
  • These companies are at both the top and bottom of supply chains.
  • Rising wages could turn a transitory inflation environment into something more permanent.

The extraordinary, coordinated fiscal and monetary response to the COVID-19 crisis has all eyes awaiting a rise in inflation – and the increase in central bank policy rates this could bring. We believe this is a real risk in the medium term. But in the short term, we see rising prices as transitory – the result of pandemic-related dents to supply and a post-pandemic surge in demand. As we discuss in our Q2 Stock Market Monitor, this is an important consideration for investors: The companies that can pass these temporary price rises on to their customers will be in a strong position to beat earnings expectations – and potentially realize a 2021 share price gain.

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A rare price environment

The abrupt COVID-induced stop-start of the global economy has led to a unique pricing environment. Production across industries was slowed or shut down during the pandemic, and now supply is only edging back as demand begins to soar. People are investing in their homes, cars are in high demand as public transport remains unpopular due to COVID concerns, and government infrastructure spending is beginning to kick in. Surplus consumer savings – supplemented by government cheques in the U.S. – are set to flow into the economy as lockdowns ease.

The prices of home appliances offer an example. Fierce competition historically has made it difficult for appliance makers to pass higher production costs on to customers. Today, however, strong demand for appliances means the rising prices of raw materials, such as steel, are being passed through to the end product buyer. In China, prices of air conditioners have jumped by around 10% twice since December last year[1]. And in the U.S., household appliance prices have been rising by around 15% year-over-year for the past few months. See the chart below.

[1] Goldman Sachs, March 2021

Accelerating appliance prices
U.S. major appliance price changes, 2017-2021

Source: BlackRock Fundamental Equities, with data from the U.S. Bureau of Labor Statistics, April 2021. The chart shows the monthly year-over-year change in the major appliance component of U.S. consumer price inflation (CPI). The data is not seasonally adjusted.

The importance of pricing power

We believe companies with strong pricing power are predominantly found at the top of supply chains, or at the bottom – and a good brand is key.

Taking from the top

Sellers of raw materials such as copper are in a strong position as the “green” spending promised by governments boosts the electrification trend. U.S. President Joe Biden has pledged to build around 500,000 electric vehicle charging stations over the next eight years. Cement companies can raise prices as supply remains limited and demand picks up amid broad infrastructure spending. Steel makers have hiked prices several times this year already, impacting the overall prices for iron and steel. See the chart below. And the well-publicized shortage of semiconductors is growing more severe. Semiconductors are essential for solar power, smart grid technology and electric vehicles, as well as for most consumer electronics — and makers have been able to increase prices as supply remains limited due to factory shutdowns during the pandemic.

Soaring steel
U.S. iron and steel price changes, 2017-2021

Source: BlackRock Fundamental Equities, with data from the U.S. Bureau of Labor Statistics, April 2021. The chart shows the monthly year-over-year change in the iron and steel component of U.S. consumer price inflation (CPI). The data is not seasonally adjusted.

Good brands at the bottom

Some companies at the bottom of the supply chain can pass higher input costs on to consumers – but it’s important to be selective. Car makers may be able to pass on the higher price of semiconductors because the cost of chips – a few hundred dollars – is a small portion of the overall car price. Yet pricing power is most apparent for those car companies with a strong brand, many of which are in the premium section of the market. Meanwhile, we see the large, well-known construction materials companies taking market share from smaller players by investing heavily in their own inventory and passing those costs on to the end consumer willing to pay the price for faster delivery.

Stuck in the middle

The companies that may struggle to pass on rising costs are likely to lie in the middle of supply chains, in our view. Suppliers of car parts, for example, are trapped between the semiconductor makers who can charge higher prices, and the automakers who can impose penalties for delayed delivery. The higher the proportion of raw materials in the product, the harder it is to pass on costs. This means machinery makers may struggle, as well as the solar panel makers who have to pay up for polysilicon.

Actively watching wages

Rising wages could turn this transitory inflation environment into something more permanent. Investors at BlackRock Fundamental Equities speak to thousands of companies a year and, so far, are not hearing about greater labour costs. We will be watching this closely – especially in the low-skilled areas of the market that are set to see a surge in demand as economies open up. For now, there is still excess labour as furloughed workers are brought back into the workforce.

Navigating this changing inflation backdrop is an ongoing and active task. As such, it is one we believe is best navigated by active stock pickers who can do the company-by-company research necessary to discern the potential winners and losers.

Nigel Bolton
Co-Chief Investment Officer of BlackRock Fundamental Equities