Sector exposure is more than ever a key investment consideration when constructing portfolios. What’s the outlook for each and how will key sectors fare with higher inflation, higher interest rates and the potential for an economic slowdown? Following the release of the FY23 Sector Outlook from our Credit Research team, here we discuss the implications for Financials, Real Estate, Materials/Commodities, Utilities, Infrastructure and trading implications.
Background
Since the second half of 2021, headlines in financial markets and the broader economy have been dominated by high inflation and the normalisation of monetary policies. There is a broad consensus that inflation will remain elevated for the coming months, interest rates will continue rising and this will translate into a slowdown of the economy. With this being the focus, FIIG’s Credit Research team has released its FY23 Sector Outlook, one of many publications available to FIIG clients. We have provided a shorter snapshot of the report below, which reviews how these three components will influence the key sectors of the economy.
Financials
Companies in the Financials sector are typically not directly exposed to inflationary pressures, with the main exposure tied to their cost base. Across the entire Financials sector, we see insurance companies as the most exposed to high inflation, given cost pressures should lead to higher claims costs (assuming a constant number of claims), although we would expect insurance companies to offset these with higher premiums charged. We note this likely trend of higher insurance premiums will also be influenced by greater claims costs due to recent weather events, including the floods on the East coast of Australia.
Higher interest rates are typically positive for companies in this sector because they will gradually re-price their products at a faster pace than the re-pricing of their liabilities, meaning a higher net interest margin (as illustrated in the chart below). High interest rates should also drive better investment income, especially for insurance companies (although they will initially see non-cash loss due to adverse market valuation movements). On the other hand, higher interest rates should also translate into slower asset price growth that would then drive a slowdown in credit growth and lower churn.
Net Interest Margin
Real Estate
Companies in the Real Estate sector will generally benefit in a high inflation environment for a few key reasons. The first is that property leases (which will generate the bulk of revenue for companies like REITs) will typically be linked to inflation which should translate to some revenue upside. The second is that their level of operating costs are typically quite low (as reflected by a high EBITDA margin) meaning there is limited impact on the cost side.
However, it is not to say there would be no impact, since development costs will also rise significantly which may erode any profit margin on developments (especially in situations of projects with significant levels of pre-sales when the construction costs had not yet been locked in with a construction contractor), which may translate in certain projects (not yet commenced) no longer providing an adequate return on investment.
A secondary effect of this slowdown in new developments is that available stock and inventories should then decrease, resulting over time in support for prices. This effect though will take time due to the need to digest the current development pipeline coming to market. We also note that companies in the sector are exposed to the stress currently experienced in the construction sector and associated failures of contractors (which would result in developers becoming exposed to ongoing price risks despite the typical fixed price contract used in the sector).
An economic slowdown would be expected to translate into lower demand from prospective tenants or a reduction in leased space. We would expect a proportionally greater impact for office space and, to a lesser extent, industrial space, given the modular nature and the ability of office space tenants to downsize without entirely moving out. The position is different in the retail space, since this is more of an ‘all-or-nothing’ proposition. The level of non-discretionary retail exposure will also be important, since we would expect demand in that sub-sector to remain solid (by virtue of the space being dedicated to support activities which are essential).
Materials/Commodities
The performance of companies in the Materials sector (and, for the purpose of this report, we are focusing on Commodities) will typically be tied to the performance of the relevant commodity prices which have shown a high level of volatility over the past two years, largely because of the pandemic.
While the Commodity sector has been historically highly exposed to sudden drops in commodity prices, the sector has been a lot more disciplined in recent times whereby new investments (especially at times of high prices) have been more targeted, resulting in global production levels remaining closer to the over-the-cycle average demand. In turn, this translates into better upside in good times and lower downside in bad times.
While many commodities are currently trading at a significant discount to their highs since the start of the pandemic, they are generally trading higher than their averages leading into the pandemic. The exceptions are iron ore (which benefited from supply constraints from Brazil pre- pandemic) and coal (currently benefiting from the material step change in oil prices since the start of the Ukraine conflict). This means that many companies in the Commodity sector are still generating healthy margins despite the recent price movements.
Inflation will typically impact commodity companies through higher production costs (especially in relation to labour and fuel costs) but, absent a scenario which would see production levels materially higher than demand, higher costs should translate into higher realised prices on the basis that the clearing price of a commodity should be equal to the production costs of the marginal producer (noting this equation may not hold for finite periods but should over time). Commodity producers in the third or fourth quartile of the cost curve will invariably be a lot more exposed to inflationary pressures.
Commodity Price Movement Since 2017 (Base Price June 2017 = 100)
Utilities
While the Utilities sector is quite broad, we focus primarily on regulated utilities, which comprise electricity and gas transmission and distribution businesses. These companies are regulated due to their monopolistic position. We typically differentiate regulated utilities from the broader infrastructure sector for certain structural protections that are specific for these companies.
A key of the regulatory framework is that the regulator determines a company’s revenue to ensure that it can provide services in an efficient manner. The regulator will also provide sufficient revenue to deliver a return on assets (proxy for debt costs and dividends to shareholders) and return of assets (proxy for depreciation and amortisation). Importantly though, the regulatory framework is designed to largely remove inflation and interest rate risks (instead of passing on those risks to utility companies, but also allow for the cost linked to this risk to pass through).
Higher inflation is generally positive for regulated utilities, since the value of the regulated assets will be adjusted by inflation, which will then drive a higher return of and on assets. It is not to say companies in the sector are completely insulated since their cost base will also increase, but they typically operate at a relatively high EBITDA margin. It is also worth remembering that, although capital investments could come higher than forecast due to inflation, the higher value can be rolled into the regulated asset base (rather than the budgeted amount), provided it is determined that the increase was reasonable.
Higher interest rates are generally detrimental to regulated utilities given the high debt load carried by these companies (compared to traditional corporates). However, the regulatory framework also provides a degree of protection with regular tariff resets which use, amongst other things, the prevailing interest rate. This means that regulated utilities are in practice more exposed to idiosyncratic moves in debt spreads, noting that companies in the sector will typically hedge their base interest rate exposure to match the periodic tariff reset.
Infrastructure
While the definition of infrastructure has considerably widened in recent years, our focus remains on what is viewed as traditional core infrastructure, i.e. airports, roads, rail and ports. This is because they operate under very similar regimes and have drivers generally consistent across each sub-sector.
High inflation is generally seen as a positive for the Infrastructure sector because tariffs (and therefore revenue) are typically inflation linked and yet operating costs are comparatively low (e.g. airports and toll roads will typically operate at an EBITDA margin that can be in excess of 70%). But high inflation may also have an impact on the cost of capital investment, noting the sector generally uses fixed price contracts for large construction projects, which removes price escalation on existing on-going projects. Higher construction costs could however impact the return of future investments not yet committed.
Similar to the Utilities sector, the Infrastructure sector is characterised by high debt levels (compared to traditional corporates), reflective of the predictability of their earnings. This means that any increase in interest costs will impact cash flows, since, unlike regulated utilities, infrastructure companies will generally not have the ability to offset these debt cost fluctuations (unless there are specific mechanisms in place, a consideration that is company specific rather than applying to the sector as a whole). Infrastructure companies have typically mitigated the risk of fluctuations in interest rates through high levels of interest hedging as well as well-staggered debt maturity profile, the latter ensuring that any debt repricing will only impact a small portion of the overall debt portfolio.
Trading implications
While we always believe portfolios should have a well-diversified profile, given higher inflation and higher interest rates which could see an economic slowdown eventuate, it is more relevant than ever. While portfolio construction should consider the worst, it is also important to have a mix that should perform if and when a soft economic landing eventuates.
Given the current outlook, we prefer larger allocations to investment grade credits, which by their very nature have stronger balance sheets and are better at weathering downturns. With these stronger credits we would also expect less capital price volatility from spread movements, and more comfort looking through any periods of valuation weakness knowing coupon payments and capital repayments come maturity are expected to be met.
While some investors may have shied away from adding longer dated fixed bonds given the rate hiking environment, currently they provide attractive entry points trading at significant discounts to face value, and we would expect capital upside should we see a recession play-out (all else being equal) with investors seeking safer investments. We would consider these to be a core holding in any portfolio.
A diversified portfolio with a mix of floating rate, fixed coupon and inflation linked bonds will better protect fixed income portfolios whatever may eventuate.
The full FY23 Sector Outlook report is available to FIIG clients only, along with other such publications. Please speak with a FIIG representative to find out more on becoming a client.