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Quality stocks to flourish amid high inflation

Based on previous periods of high inflation, solid growth equities should deliver attractive performance, according to BNY Mellon Investment Management (BNY Mellon IM).
Blue arrows moving up to indicate stock market growth

Analysis of stock market returns during environments of higher inflation suggests investors should look to allocate to global equites over the long-term to ride out volatility.

“A look at history shows that equities have held up well during periods of higher inflation,” said BNY Mellon IM client investment manager George Dent.

The firm believes that levels of inflation will likely remain high over the medium-term because of a combination of factors, including elevated energy and raw materials prices, higher interest rates, a tighter labour market, and supply chain issues, especially in some Asian countries due to zero-Covid policies.

High expectations

According to Dent, the pent-up demand in economies generated during the pandemic is a positive for equities, with any subsequent spending wave likely to benefit certain companies.

Using the UK as an example, the Consumer Price Index (CPI) ran at an average of 7.6% a year during the 1980s – representative of the current expected level of inflation. During this time, equities delivered a real return of 11.7%.

Meanwhile, during the 1940s, when inflation averaged 6.1% annually, equities returned 6.3%.

“Looking back at the last 100 years suggests equities are not going to be too bad a place to be if we are going into a more inflationary environment,” explained Dent.

Quality not quantity

For investors seeking exposure to equities, however, they need to factor in that not every company will navigate a period of higher inflation and interest rates in the same way.

In Dent’s view, quality growth companies are well placed to ride out the bumps in the road created by higher prices.

“It’s these characteristics [of high profitability, a strong balance sheet and pricing power] that should allow companies to weather a more inflationary environment with relative ease,” he added.

Combining the core attributes of quality with a focus on those businesses that benefit from good structural tailwinds creates a skew towards areas like healthcare and technology, and away from sectors like financials.

More specifically, the current environment suits automation business that are set to benefit from wage inflation. “The more wage inflation there is, the greater the incentive for companies to automate their processes,” said Dent.

Payroll processing firms also offer a good way for investors to benefit from a rising rate environment, especially if they aren’t comfortable investing in banks, given these institutions can be highly leveraged and opaque.

“Payroll often becomes deeply entrenched in businesses and as such, it has sticky customers,” Dent explained. “Payroll companies can also benefit in tandem with rising wages and in a higher interest rate environment because they tend to sit on a lot of cash.”

It is also notable that to find the best opportunities, a short-term perspective of around 12-to-24 months will unlikely be as effective as identifying a select group of high-quality industry leading growth businesses, he added.

Part of the Mark Allen Group.