Shares the pros are backing to shine as inflation cools

As major central banks around the world start to cut interest rates, it suggests that inflation is – if not quite vanquished – then at least in retreat. Across the UK, US and Europe, inflation has been at or near official target for several months, with the post-Covid bottlenecks and energy shortages that created it receding.

High inflation – and the high interest rates that come with it – has been particularly difficult for some companies. Companies with high debt, for example, or those that require higher capital spending – think wind farms, manufacturing businesses or airlines – have struggled.

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In addition, high inflation tends to depress consumer confidence, which has been difficult for companies that rely on households having spare cash.

Against this backdrop, investors have retreated to some old favourites, mostly the US technology giants. More recently, however, there have been signs that financial markets are responding to a change in environment. NVIDIA Corp (NASDAQ:NVDA)’s recent 122% rise in revenues was greeted with a shrug by investors, suggesting that they may be looking for a change.

There are plenty of potential beneficiaries of inflation cooling. It should be good for consumers, putting more pounds in people’s pockets. Energy and commodity prices are falling, easing the pressure on businesses where they are an important part of their costs. A range of businesses also benefit from lower borrowing costs, allowing them to invest and spend.

Potential winners?

Fund managers on the ii Super 60 list are cherry-picking the likely winners from this new environment. Marcel Stotzel, portfolio manager on the Fidelity European fund, for example, has been investing in Ryanair. The company’s share price has been volatile, but has started to recover from its August lows.

Stotzel says that it is well run, “with a laser focus on cost, solid cash generation, and a very young fleet which it fully owns”.

He adds: “Although its recent results sprung a bearish surprise on the market, we are confident this is a relatively idiosyncratic issue which shouldn’t affect the long-term bull case for the stock.”

He says the stock sell-off has provided an opportunity with the company trading at valuation levels last seen during Covid.

“It should benefit from lower inflation in terms of potentially weaker crude oil prices feeding into lower jet fuel costs, which can help margins. On the cost side, reduced wage demands from staff could also be a positive. And on the customer side, lower inflation would mean consumers have more disposable income - potentially bullish for Ryanair and other travel/experience stocks.”

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The attention on artificial intelligence (A)I has focused on the obvious beneficiaries – Amazon.com Inc (NASDAQ:AMZN), Microsoft Corp (NASDAQ:MSFT) or Meta Platforms Inc Class A (NASDAQ:META). However, there are plenty of companies further down the supply chain, which are also benefiting from its growth, but that don’t yet have the premium price tag.

Legrand SA (EURONEXT:LR), for example, is a century-old French electrical company that Stotzel describes as a “picks and shovels” play on AI.

He adds: “Its data-centre business provides fuses, server racks and other ‘white space’ products which are typically the last parts added in data-centre construction. Its data-centre business is around 15% of revenue, which is big relative to its peers and should grow at double-digit rates going forward.

“Some of the more obvious European data-centre plays –Schneider Electric SE (EURONEXT:SU), notably – are far more richly priced. Lower inflation should mean lower interest rates, which should also be a positive for investments in long-duration growth themes like AI – and by extension, Legrand.”

Falling costs

One of the key reasons for high inflation has been the spike in energy costs created by the Ukraine crisis. Energy is an important input for many companies, but those with greater energy needs should receive a boost from falling prices.

Indriatti van Hien, deputy fund manager of Henderson Smaller Companies Ord (LSE:HSL) Investment Trust, says: “As these costs have abated, we see scope for certain UK domestic companies to benefit from these headwinds turning into tailwinds for earnings.

“Johnson Service Group (LSE:JSG), a workwear and linen rental services provider to the hotel, restaurant and catering industry is seeing margins rebound as a result of falling energy prices. These costs are a significant line item for a company where the washing machines and tumbler driers are always on.”

She also holds Mitchells & Butlers (LSE:MAB), which is geared into falling energy prices and improving household spending. “Falling food inflation is also acting as a tailwind here. Both these companies are exposed to the casual dining industry and are continuing to benefit from recovering UK consumer confidence.”  

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Job Curtis, portfolio manager of City of London Ord (LSE:CTY) Investment Trust, picks RELX (LSE:REL) as a likely winner from the new environment. The company provides information-based analytics tools for professional and business customers. It owns legal specialist LexisNexis, for example, whose proprietary data puts it in prime position to harvest AI insights.  

Curtis says: “RELX should be able to continue to grow its profits consistently in a low inflation environment because its tools are becoming increasingly sophisticated, and are vital for customers, helping them to be more productive and effective. In a period of low inflation, those companies that can add value for their customers, such as RELX, should outperform. In contrast, companies that have previously relied on inflationary price increases will struggle.”

Scott McKenzie, manager on the WS Amati UK Listed Smaller Companies fund, has dialled up the risk in the portfolio in expectation of a economic and market recovery. His focus has been on buying “higher-quality companies at bargain prices”, including a higher exposure to areas such as financials. That includes wealth and fund management businesses, including Brooks Macdonald Group (LSE:BRK), and private equity group Pollen Street Group Ltd (LSE:POLN).

An alternative scenario

Nick Langley, manager on the FTF ClearBridge Global Infrastructure Income fund, has a different perspective, believing that inflationary pressures could re-emerge. He says that while short-term inflation is falling, he sees some structural pressures likely to keep inflation higher in the longer term. This includes moves by companies to bring supply chains closer to home, which will raise costs, while curbs on immigration could raise wages. The energy transition could also be inflationary.

Infrastructure assets tend to provide protection against rising inflation, through regulation, concession agreements or contracts, but the relationship isn’t exact. There may be a delay between inflation occurring in the real economy and it being reflected in infrastructure cash flows. “For a number of our US holdings, we’re only getting the inflation coming through from 2022. We’re getting a historic inflation boost even though inflation has dropped,” he says.

His current holdings include Severn Trent (LSE:SVT). He says there has been a lot of volatility for listed water companies, which are going through a regulatory re-set. He says a lot of the uncertainty surrounding the water companies should clear when the regulators announce their final decision at the end of the year.

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He notes: “When that final decision comes, we should be able to see their path for the coming years and they can talk about their longer-term plans. We think Severn Trent will increase its asset base by around 30%. They should be earning higher returns than they have done in the last regulatory period.” These “bond-proxy” companies with high dividends should look more appealing in a lower inflation environment. 

He also likes NextEra Energy Inc (NYSE:NEE) in the US. Half its business is a regulated electricity in Florida, which is seeing strong asset base growth, driven by both the energy transition, and so-called resilience spending. This is in response to regulator demand that it strengthens the grid against increasingly powerful hurricanes. The other half of its business is the largest renewables business in the US. It has a pipeline of wind, solar and battery storage assets. It has seen its development costs fall as inflation has dropped.

It is plausible that inflation will be more volatile over the next five years, but the immediate threat has passed. This means many of the companies that have struggled may find their feet again. There has already been a nascent recovery in many areas and this could build momentum if inflation remains on track.