Importing trouble

I say so for a simple reason. Many stock market sectors are negatively correlated with non-oil import prices. Rises in import prices, as my table shows, are associated with falls in share prices in several sectors.

My table shows contemporaneous correlations, which creates a puzzle. Such correlations should be low. This is because import prices respond to sterling's moves with a lag - because of fixed-price contracts or because overseas exporters are slow to change prices - and so stock markets should discount their impact in advance. If they did, contemporaneous correlations would be zero because a fall in sterling would immediately depress the prices of shares in companies that import a lot.

The fact that contemporaneous correlations are significant in many cases thus tells us that markets don't fully and immediately discount the bad news of higher import prices. This bad news is, of course, that higher import costs often squeeze profits. My table shows that the biggest losers from higher import prices are, as you'd expect, sectors that import a lot: retailers, transport and construction companies.

Now, you might object here that my table in fact captures something else entirely. Sterling tends to fall, and import prices therefore rise, during financial crises and it is these crises rather than higher import costs that hurt shares.

But this isn't the whole story. Even if we control for moves in the stock market, there remains a statistically significant negative correlation between import prices and many sectors such as banks, general retailers and construction companies.

All this suggests that some shares might be under-reacting to sterling's moves. Perhaps investors don't fully appreciate the damage higher import prices do until companies warn them of it.

This poses the question: how can we protect ourselves against this threat?

One possibility is that we might not need to. If interest rates stay low and if chancellor Philip Hammond sticks to his promise to "reset" fiscal policy, loose policy might support domestic demand sufficiently to allow companies to pass on higher import costs - although this would of course come at the price of higher inflation. This is an especial hope for construction stocks that would benefit from increased public spending on infrastructure.

Another possibility is to look for sectors that aren't hurt by higher import costs. As you'd expect, these include global companies that benefit from a weaker pound, such as the oil majors and pharmaceuticals.

Also, some defensives such as beverages and utilities are unaffected by higher import prices. This category includes food retailers - perhaps because they have the market power to ensure their suppliers suffer instead.

Herein, then, lie the questions stock-pickers should ask of their holdings: can I really be confident that the damage done by higher import costs is fully priced in? (Maybe not). Might it be offset by looser policy? Are my holdings sufficiently globalised to avoid the pain? Or do they have the market power to ensure they can pass on the costs to suppliers or customers?

There's always a case for holding large defensive stocks. Perhaps this is especially true now.