Stock Takes: Which stocks will weather the inflation test?

Now that high inflation is upon us, investors are turning to the upcoming reporting season to find out which companies are handling it best.

Stats NZ said annual inflation came in at 5.9 per cent in the December year – the highest level since 1990.

That means higher interest rates are on the way, on top of the myriad challenges posed by year three of the Covid-19 pandemic.

While the second half of last year was not a bad one for many stocks, analysts have been paring back their company earnings forecasts in preparation for what may lie ahead.

February will see a slew of interim results for the six months to December 31.

“We are going to be watching the results very closely,” said Harbour Asset Management portfolio manager Shane Solly.

“It’s not just the rising cost of labour. It’s going to be things like petrol and productivity becoming constrained by more people working from home.”

The big sick

What has been termed “the big sick” – people away sick or in isolation due to the Omicron variant of Covid-19 – has the potential to be highly disruptive, creating earnings issues for many companies, depending on how it all plays out.

Sam Trethewey, portfolio manager at Milford Asset Management, said the key will be how the Government manages isolation requirements as cases become more widespread, noting that the Australian Government had backed away from longer isolation requirements.

Logistics company Mainfreight and retirement village operator Ryman, both of which have substantial operations in Australia, have already had a taste of things to come.

Upcoming earnings

Trethewey expects most of the results due out in February to be reasonably strong.

“The New Zealand economy up until the end of Christmas had been fairly buoyant, and in the middle of the year was running at full steam.

“What we have seen coming out of Australia in the past few weeks has been a large number of downgrades, particularly from the retailers who havebeen hit by the lockdowns and by people just not getting out there and spending for fear of catching Omicron,” he said.

The sector had seen downgrades from footwear retailer Accent, homeware company Adair, and high-end clothing retailer Universal Store.

“There is a risk that can play out in New Zealand in the coming six moths as the Omicron variant becomes more prevalent in the community,” Trethewey said.

He says pricing power – the ability of companies to pass on costs to the consumer – had been easy in the past three or four months but that could change in the next six months.

“And we may see the pressure go back on businesses that have had a pretty easy runsince Covid-19 – there has been lots of stimulus and with lockdowns stimulating demand.

“It’s been an easy environment for companies to maintain margins over the last 24 months while Covid has been around because there has been such strong demand.”

Results from the retailers are likely to generate a lot of interest, as will the retirement sector, along with bellwether stocks Fletcher Building and courier company Freightways.

Covid disruption

Domestically, economic consultancy Infometrics said theOmicron outbreak will disrupt New Zealand’s economic recovery.

It said challenges would be faced due to limits on events and hospitality activity, high levels of employees off work, and difficulties finding some goods.

“Limitations on the number of people at venues and events, supply disruptions, absenteeism and lower economic participation will all combine to restrict economic activity,” said Infometrics’ principal economist Brad Olsen.

“At red [alert level], restrictions on activity are expected to keep GDP 2-3 per cent below usual levels, costing $190m per week.

“But the hit to the economy could well be larger, with difficulties keeping workplaces operational with enough workers and materials further restricting output.”

Estimates suggest that up to 12 per cent of the New Zealand workforce could be absent from work, with wide variations possible.

Examples from Australia show considerable challenges for transport, logistics and supermarket operations, he said.

In good company

The New Zealand sharemarket fell into technical correction territory – a fall of 10 per cent or more from its recent peak – this week but it is in good company.

Major bourses around the world are approaching bearish milestones as worries mount about the prospect of higher interest rates in the world’s biggest economy – the United States.

Sabre rattling between the Russian and US superpowers over the fate of the Ukraine is clearly making matters worse, while the onset of the Omicron variant of Covid-19 is widely expected to curtail world growth.

Japan’s TOPIX index fell into correction mode this week and Australia’s S&P/ASX200 is heading that way. South Korea’s Kospi is down 17 per cent from its July peak.

Hong Kong’s Hang Seng Index is already in a bear market – a decline of 20 per cent or more – as are some major indices in mainland China.

Aged care pressure

Broker Forsyth Barr says the arrival of Omicron has accelerated the underperformance in the aged care companies, whose share prices have dropped by about 20 per cent over the last three months, underperforming the S&P/NZX 50 Index by about 10 per cent.

“We believe the sell-off is a combination of nervousness around residential house prices, and fears around what the consequences of Omicron will be for the sector.

“Neither of these issues are likely to go away short term, however valuation support is starting to look very strong, particularly for the smaller aged care names.

“Near-term we see momentum keeping the upper hand but on a 12-month and longer-term view we continue to view the aged care sector as attractive,” Forsyth Barr said.

In the sharp sell-off of 2020, the aged care names were sold off very aggressively but recovered quickly.

Persistent headwinds

New Zealand went into the red traffic light setting on Sunday due to community spread of Omicron.

This will hit the aged care sector in two key ways: sales activity is likely to reduce significantly during the acute phase of the outbreak, which could last for several months; and operating expenses are likely to increase, Forsyth Barr said.

The sector has navigated previous outbreaks relatively unscathed and has the benefit of almost two years of preparation.

“However, this outbreak will be different and meaningful outbreaks at aged care facilities are highly likely,” it said.

The New Zealand aged care companies make the majority of their underlying earnings from new sales and resales of independent living units, and those sales are highly geared to house prices, it said.

“We are of the view that the risk of a meaningful house price correction has increased significantly over the last six months.”

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