We are in uncharted territory. You have to go back to 1982 to find the UK inflation rate at current levels – almost double the long-term average since 1949.
Households were the first to feel the pressure, and with discretionary income receding, we may be rapidly approaching the point where businesses are no longer able to pass on cost increases to consumers. Statistics suggest that we may already be there.
The rate of producer price inflation has reached its highest level since records began and is already exceeding ex-factory prices. It is significant that the gap between the two measures is widening. This could reflect a possible shift on the price front. But it could also signal that consumer demand has become more sensitive to inflationary effects. While this does indeed indicate increased elasticity of demand across the board, any further increases in input prices are likely to eat into corporate profits.
The Dow Jones Industrial Index is now on its longest losing streak in 80 years. And the market appears to price in a prolonged economic downturn, as few investors now believe central banks will be able to contain inflation while avoiding measures that stifle economic growth.
On the home front, there is a silver lining as wholesale gas prices in the UK are falling in response to an unprecedented surplus of liquefied natural gas. And at the time of writing, Britain’s benchmark FTSE 100 index was holding up better than its US counterparts. This may be due to the heavy weightings assigned to old-world industries, the very reason why the FTSE 100 drew regular criticism when tech stock valuations soared.
Irony aside, the Nasdaq Composite Index has lost 28% of its value since the start of the year, but the technology rout may still have some way to go even if the average price/earnings multiple of the index, which currently stands at 21 times, is down a third since the start of the year.
Perhaps the most reprimanding news of the past week came from across the Atlantic, as shares of Target Corp (US: TGT) and Walmart (US: WMT) fell sharply after U.S. retailers released quarterly earnings updates well below analysts’ expectations due to inflationary impacts and changing consumer habits.
The loss in earnings demonstrates that traditionally defensive stocks are also vulnerable when inflationary pressures run wild. Department store chains typically provide a safe haven for investors when the economy slumps because demand for the groceries and other essentials they sell is largely inelastic. But these types of retailers also operate on rather thin margins, so profits are at risk whenever the rate of inflation is high for an extended period.
With defensives on the defensive, investors might be well advised to consider the other end of the retail spectrum. The luxury goods market is not recession-proof, as many proponents would have us believe, but it has proven surprisingly resilient in previous recessions. It has been shown that in times of inflation, demand for luxury goods often increases because historic brands retain value and do not depreciate. Add to that the fact that affluent customers have less difficulty during economic crises and you can see why the luxury sector is a viable option for investors, even if it may seem counter-intuitive to some.
Admittedly, the S&P Global Luxury Index is now trending lower, largely due to China’s strict containment measures in response to the Omicron variant. But over the past 10 years, it has generated an annualized return of 8.7%, while the share price of one of the main constituents of the CAC 40, LVMH Moet Hennessy (FR:MC), increased by 456% over the same period. And unlike some tech stocks, its rating is largely based on rising earnings.
Naturally, in the months ahead, many investors will be sifting through the tech sphere in search of quality growth stocks that have been caught up in the selloff. But it should be noted that Chinese consumers of luxury goods are relatively well placed to escape the economic blow caused by the recent restrictions.
Authorities in Shanghai and elsewhere in China have begun easing restrictions as infection rates drop. Thus, we are likely to see an increase in sales volumes in this corner of the market due to pent-up demand from the country’s more affluent consumers. After all, the rise of the luxury goods market is closely tied to the growth story of emerging markets.