FOMC: Central bankers face conundrum on inflation and growth
Soaring inflation was already a dominant theme for markets coming into 2022. The sanctions imposed on Russia in response to its invasion of Ukraine have only exacerbated its expected rise, and pushed its expected peak further out. As an insidious destroyer of value, fixed income investors are always concerned about inflation’s impact on bond yields – but our vigilance cannot end there.
It is also crucial to consider the impact of an inflationary environment on the fundamentals of bond issuers, which can vary enormously across sectors and between companies. A backdrop of increasingly squeezed consumers is a tough setting for increasingly pressured companies to pass through their rising cost of inputs in the form of higher prices, but it is essential if those companies are to protect their margins, profitability and ultimately their ability to repay debt.
Solid credit analysis always involves researching industry structure and considering what competitive forces are acting on firms within that industry. As investors we want to understand a firm’s competitive positioning within its key markets, and whether it has a sustainable strategic advantage in those markets.
Essentially we are looking for companies that are price setters rather than price takers. Large market shares are generally helpful in that regard, but it’s also important to consider the relative power of a firm versus its customers and suppliers; we look for evidence of bargaining power against both. Historical profit margin trends are a good starting point for this, but given until recently companies had enjoyed decades of benign inflation, this needs a qualitative assessment as well. How many distinct advantages does the company have? How are these being improved and defended? If its advantage over competitors is cost leadership, how confident can we be that its input costs will stay lower than the competition and allow it to remain the lowest priced after passing on the increases? It is also important to consider how products are distributed and positioned in the market; are the firm’s goods differentiated enough to make substitution difficult?
The ability to pass through costs can be relatively easy to determine in certain industries that tend to feature plenty of investment grade issuers (water companies such as United Utilities, for example, have inflation-linked returns built into their regulatory frameworks). Similarly, when larger companies have a quasi-monopoly over a market, as is the case with US wireless carriers AT&T, Verizon and T-Mobile, while they are legally prohibited from colluding price rises tend to happen in concert and customers have little choice but to accept. When it comes to the smaller companies that dominate the high yield corporate bond market however, some deeper due diligence is required to find evidence of consistent pricing power.
One interesting example from the US is Cornerstone Building Brands, a manufacturer of windows and side panelling for homebuilders that has managed to achieve 10%+ price rises this year, more than offsetting the recent inflationary impact on its costs. What has made this possible? First, Cornerstone makes high quality products with strong brand recognition, and while they are not cheap, they are a relatively small component of the overall cost of house production. Selling a differentiated value-add product makes it harder for customers to substitute, since homebuilders are reluctant to lower the perceived value of their product (the house) by switching to a cheaper alternative. Cornerstone also has a large share of the market, which coupled with national distribution means customers have grown to rely on it. Higher switching costs help make Cornerstone a price setter. Of course, this is a competitive advantage that requires continued operational excellence and investment, and part of a credit analyst’s job is to monitor a company to ensure any advantage remains a strategic priority.
When it comes to pricing power, how you sell a product can be just as important as what you are selling. Supplying materials to other businesses like homebuilders can involve an element of contractual pass-through. If you’re providing 10,000 side panels over the course of 12 months, your contract can stipulate that the unit price will rise in line with any increase in the cost of certain inputs. Contrast this with smaller companies selling discretionary (i.e. non-essential) goods directly to retail customers. The more commodity-like your product is, the more scope your customers have for substitution and the less scope you have to raise prices. Bricks and mortar distribution on the high street might be helpful if convenience and location is a factor in the purchase (coffee), but in markets where alternatives are widely available online (clothing) it is even harder to lead on price. Differentiation is still possible, but without strong brand recognition firms are often at the mercy of changes in consumer taste. Carmakers such as Ford and Volkswagen have proven an exception to the rule on discretionary goods in recent months, but their pricing power has been boosted by a backlog of orders that built up during the COVID-19 pandemic and we don’t expect it to last.
Performing the necessary due diligence to identify companies with the requisite pricing power to prosper in the macro environment we are now entering, and those without, is an essential part of prudent active management. Companies with strong pricing power tend to see lower volatility in their profits, which is exactly what we look for as credit investors. Better revenue stability and profit predictability help constrain credit spreads in times of market stress, and they are attractive characteristics in a bond issuer at a time of considerable economic uncertainty.