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Saturday, 14 June 2008

Inflation won’t derail equity markets, says Citi

By Rita Raagas De Ramos,

Robert Buckland, chief global equity strategist at Citi Investment Research, says inflation isn’t a serious threat and suggests taking advantage of investment themes related to rising consumer prices.
Global inflation has been rising for about a year, now standing at its highest level since 1999, and is among the main concerns of investors worldwide.

However, Citi Global Wealth Management’s analysis of the inflationary forces around the world suggests that this round of rising consumer and producer prices should not damage the equity markets or undercut their nascent recovery.

While rising costs and lower sales growth can affect corporate profits, the engine of stock market returns, it’s also important to note that commodity prices are not the most critical component of companies’ costs, says Robert Buckland, London-based chief global equity strategist at Citi Investment Research, which is part of Citi Global Wealth Management. That distinction goes to labour, which accounts for around 60% of costs, he notes.

The main concern, from a corporate profits perspective, is whether rising prices will spill over into higher wages, he says, noting that for now, there is no evidence that this is happening in developed countries. In the US, wage growth peaked at 4.2% in the fourth quarter of 2006 and has since slowed to 3.7%. In Europe, the latest figures on wage growth show just a 2.9% gain.

Labour costs in the developing world are growing at a faster clip than in the developed world, Buckland says. In China wages have been increasing by about 15% a year for the last five years and this fact has not had an impact on corporate earnings, mainly because productivity gains have offset the higher pay cheques for workers.

Although Buckland believes inflation does not pose a serious threat to investors at the moment, he suggests some strategies that investors could consider to position themselves if inflation continues to rise.

Buy the causes of inflation, he says. Higher commodity prices mean higher revenues for producers, and this bodes well for energy and mining companies. While Citi’s analysts expect commodity prices to subside, the current elevated prices may lead to higher earnings and better relative returns compared with the broad market indexes.

Follow the money, he notes. Some of the biggest beneficiaries of inflation are recycling their profits into the emerging markets. Governments of commodity-exporting nations have amassed huge reserves, and Citi has observed that emerging markets equities are seeing the biggest flows relative to the size of their stock markets.

Companies with inelastic demand are a good bet, he says. Companies that sell the necessities of life have an easier time raising prices, thereby retaining profit margins. That maxim bodes well for food manufacturers and retailers, along with beverage and tobacco companies.

Investing in companies in regulated industries is yet another worthy theme, he adds. Such companies, often in the utility and infrastructure sectors, usually do not have a hard time passing along price increases. They may benefit from legislation that incorporates an inflation index into their pricing.

“Although you may be hearing a lot about the spectre of inflation,” Buckland says, “from where we sit, it doesn’t seem like it will be severe enough to derail equity markets around the globe.”

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