The sectors that will soar when inflation hits

Bitcoin is up. Housing prices are up. Hard commodities are up. And the central banks are on a printing spree. So, is this enough to get investors thinking about inflation yet? 

Certainly, Tim Carleton co-founder of Auscap Asset Management has factored inflation into a range of scenarios for his portfolio. While he thinks the market isn't yet anticipating a trickle through to higher inflation overall, it's definitely on the radar. 

Some investors might be asleep at the wheel when it comes to inflation, but in this video, Carleton outlines an opportunity for a win-win situation whether inflation hits or not, and which sectors are undervalued right now. 

Edited transcript...

Now, you use your monthly newsletter to go into some depth on topics of interest to the market. One of the recent ones was around inflation, which is front of mind for a lot of people trying to get a pulse on what inflation might look like. Is it going to spike? Talk me through your views.

Tim Carleton:

The most recent newsletter was just an observation and the observation is fairly straightforward. We're seeing central banks and governments around the world increase the money supply quite dramatically. At the same time, we're seeing a lot of asset prices move north quite considerably in a short period. So you're seeing rising equity prices. You're seeing rising house prices, not just in Australia but in most major developed economies. You're seeing rising hard commodities. So we're very focused on Australian iron ore, but it's not just iron ore. We're seeing rising soft commodity prices. We're seeing rising precious metals prices, gold and silver a lot higher than where they were 12 months ago. You're seeing rises in alternative assets like Bitcoin.

It's not a farfetched idea that the rise in the soft and hard commodity prices at some point filters through into the cost of goods, because ultimately they are the input goods into a lot of finished products. Whether that trickles through to higher inflation, we will see, but the market is certainly not anticipating inflation being more significant than it is today. If we moved into that sort of environment, I suspect a lot of the value names would do quite well, because they are in sectors where inflation would be a real benefit to their earnings growth, whether it's the banks or the miners or the consumer discretionary retail players, they should all benefit from an inflationary environment, but we'll see.

James Marlay:

So it sounds like you spent some time thinking about inflation and I was wondering if you could give me a bit more detail. You've touched on a few sectors there. How are you specifically catering for inflation in the portfolio? Is it a central thesis? Is it a fringe thesis?

Tim Carleton:

Well, it's not central, but it's always important to consider a variety of outcomes when you're investing. Where you can get outsized returns is when you see a factor that everyone is assuming will be A, but actually B eventuates, because it provides you with an asymmetric payoff. So we like quite a lot of our investments in sectors that would benefit from inflation, even if the market is right in assuming that there will be effectively no inflation for quite some time. If we're happy with the total return offered by investments in those companies on the assumption that there is no inflation, if we suddenly get inflation, then they should do a whole lot better, because the market's currently under-invested in those sectors, because they don't see the opportunity that might come in terms of earnings growth for those companies if we do move into an inflationary environment.

Having an awareness of what the market is thinking about in relation to these sorts of aspects is important, because sometimes it provides an investor with the opportunity to invest with an asymmetric payoff.

In other words, you're happy if the status quo continues with the total return that that particular company offers you. But if we move into an environment that is more beneficial, that will lead to an even better outcome.

James Marlay:

So give me a sense of where that is in the market. You touched on banks, you talked about resources, what's an example?

Tim Carleton:

So banks are obviously a beneficiary, because if we move into a high growth environment, that's beneficial to their portfolios. Retail is an obvious beneficiary, because they tend to hold on to more margin in an inflationary environment and we are seeing some of that at the moment. You mentioned the miners, they're an obvious beneficiary, because if commodity prices are higher and moving higher more quickly than their cost structures, then they make more money. So all of the traditional havens for inflation are currently at the more attractively priced end of the market on the assumption that either there'll be no inflation, and that a lot of the increases that we've seen, for instance, in the iron ore price, will revert over time.

Iron ore is an interesting case study, because we look out and we see the potential for an increase in demand. You're obviously seeing elevated demand out of China at the moment, but the rest of the world is still consuming less iron ore and less steel than they were pre-crisis. So we would assume at some point that that will normalise and potentially even exceed the level of steel consumption that we saw previously, because we're likely to have a global infrastructure and residential boom, if we're not already seeing the start of that. If you were moving to an environment where there's excess demand and not a lot of supply coming on board and we're not seeing a huge number of projects in the iron ore space under development, that's an environment for higher prices, not lower prices. Yet everyone is assuming that at some point reasonably shortly, the iron ore price will revert to where they expected to be long term. That right now looks to us to be somewhat unlikely, but we'll see how things play out.

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