FTSE 100 constituent Mondi (MNDI) said that underlying performance during 2017 would fall short of market expectations partly as a consequence of rising wood, energy and chemical costs. Renold (RNO) warned that adjusted operating profits for its March year-end would sit slightly below the lower end of the current range of analyst forecasts. Despite rising orders, the supplier of industrial chains said that its ability to meet existing obligations had been hampered by mechanical outage at a German production facility. Of course, these things happen – even in Deutschland. However, it also cited “sustained increases in raw material costs”. Likewise Low & Bonar (LWB), which blamed “an adverse sales mix” as being partly responsible for faltering performance at its civil engineering business, in addition to raw material prices remaining at “elevated levels rather than reducing as anticipated”.
Obviously, you can’t look at these examples in isolation, but if they do form part of a wider trend, then there are potential implications for stock prices to take on board.
It’s generally held that the effect on valuations through ‘cost push’ price increases largely depends on whether the inflationary pressures have been expected – or priced in – by the market. If they have, then studies have indicated that correlations to stock valuations are variable. Conversely, unexpected inflation has demonstrated more conclusive findings; namely, a strong positive correlation to stock returns during periods of economic contraction.
Inflation hit 3 per cent in September – its highest level in more than five years. Bank of England governor Mark Carney warned it was “more likely than not” that prices would increase further in October and November, sparking the usual hyperbole in news reports. It has been reported that fund managers have been gradually increasing the proportion of index-linked bonds in portfolios as a bulwark against inflation, but the atmosphere in markets is hardly febrile. Across the pond, the yield gap between 10-year US Treasury bills and inflation-protected treasuries remain narrow from an historical perspective. And lest we forget: earlier this year, the UK raised £4.5bn through the sale of a 50-year inflation-linked bond offering the lowest ever inflation adjusted return for a UK government bond. So even if we assume that markets have identified a nascent inflationary trend, they’re hardly pricing in a Weimar Republic scenario, as some of the more politically motivated tabloids would have us believe.
That manufacturers are starting to feel the pinch is hardly surprising when you consider that the UK purchasing managers index (input prices) went into uptrend during the third quarter of 2015, before peaking in the first quarter of this year, then settling at a level well in advance of the five-year average. Indeed, the Barclays Commodity index (ex energy) shows a similar pattern, so we may even wonder why margins haven't come under pressure sooner. The reality is that there is always a lag in these matters simply as a consequence of hedging programmes in place and inventory levels. For manufacturers another critical factor is the extent to which they’re able to pass through price increases to customers, although even if they’re wholly successful in this regard it can still have a negative effect on aggregate demand.
