While elevated levels of demand and COVID-induced supply chain disruptions have presented major challenges in 2021, inflation headwinds are expected to persist this year, Joseph Koh and Ray David, portfolio managers for the Schroder Australian Equity Long Short Fund, said.
Inflation headwinds have a twofold impact, the pair explained.
“The first is a direct hit to corporate profits, as not all companies can pass on rising prices,” Mr Koh and Mr David said.
“The second is higher bond yields, which constrain valuation multiples paid for equities.
“The latter is a far more material issue, as declining bond yields and rising earnings multiples has been a multi-decade tailwind for equities, especially for the technology and small cap sectors,” they noted.
Looking at where 2021 has left us regarding domestic equities, Mr Koh and Mr David explained that domestic equity valuations have more than fully recovered since the initial COVID sell off, as fiscal stimulus has buoyed corporate earnings and monetary policy stimulus floored bond yields.
“Industrial corporate profits also benefited from cost-cutting programs as management anticipated a collapse in revenue, which did not eventuate. Most companies we talk to are now experiencing the negative jaws of slowing revenue growth, and cost inflation.
“Cost inflation is being driven by the need to hire back furloughed workers, who are now demanding higher pay rises given labour shortages. At Schroders, we expect this will pressure corporate earnings, leading to negative earnings revisions across the market,” the pair said.
At the same time, they warned, central banks are reducing stimulus programs, which is leading to higher discount rates.
“Overall, this paints a challenging picture for equity valuations, especially for those equities which were bid up to record high multiples as analysts extrapolated elevated earnings and profit margins.”
As for the push for sustainability and improved governance actions, the pair believe this will only continue to increase from here.
“Investors and corporations are increasingly recognising that individuals want more measurable social and environmental accountability alongside financial returns. Some key areas ESG investing is addressing climate change, wealth inequality and child labour.
“Addressing these issues leads to a better and more sustainable world.”
