Quality shares watchlist and the threat of 'not quite' stagflation

Not quite stagflation, but underwhelming growth and uncomfortably high (but just about manageable) inflation seems to be the situation western economies are facing. Quality shares are expensive relative to interest rates if compared with five-year averages but the attributes of pricing power, robust margins and a proven ability to generate returns on capital invested may be worth paying for.

Wage growth has been cited as a cause for the Bank of England to be concerned, after all inflation is too much money chasing too few goods and services, but the UK’s overall CPI print came in lower for July at 6.8 per cent (albeit with sticky core inflation running at 6.9 per cent). The Bank of England still has more to do but higher interest rates should work by encouraging more saving (banks are slowly passing on the higher rates) at a time when consumers are worried about house prices and the early signs of a slackening in the labour market. Throw in the fact mortgages are expensive, sucking up that wage growth, and inflationary consumer spending should cool. 

It’s a tricky balance, however. Going into a presidential election year in 2024, the likelihood of US government spending and tax cuts (fiscal stimulus) could ramp up and export inflation, even if by then it looks as though the beast is being tamed. Therefore, there may be no leeway to stimulate the economy through cutting rates (monetary stimulus) if growth is anaemic. 

That’s a problem because China’s stalling economy is causing reverberations across Europe and recession spreading will be bad for the earnings prospects of UK-listed companies. Those that have a track record of defending margins in tough times will be important holdings in equity portfolios. 

Being essential to their customers and pricing power is key to company performance but for investors, so is being able to buy the shares at a reasonable valuation. With this incredibly difficult confluence of macro factors it is hard to tell what a reasonable price is for many companies’ shares.

Quality shares for tough times

The process of evaluating companies in our watchlist is fourfold. First, we check the core credentials of EBIT margins and returns on invested capital (ROIC). Second, consider whether a business has high operational gearing (are a large proportion of operating costs fixed) and whether this is likely to work for or against the company in the short to medium term. Third, review the growth outlook, momentum in the direction of analysts' earnings forecasts and understand the risks to these drivers. Fourth, we look at whether shares are cheap or fair value compared to their history versus the rest of the stock market (and against government bonds). 

Finally, it is always worth considering other quality shares that aren't on the watchlist. It is good to guard against an 'endowment effect' by screening for other ideas. Alongside this watchlist report, our latest quality shares Alpha screen provides some different and fresh ideas.