A European Stock Trader’s Guide to an Era of Scorching Inflation

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(Bloomberg) –

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Rampant inflation has been at the core of the equity selloff this year, and it won’t go away. Now comes the hard part: positioning yourself.

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In theory, rising prices should favor cheaper, so-called value stocks, such as banks, while undercutting growth stocks. Interest rate hikes to keep prices in check mean bigger profits for lenders, while hurting tech stocks by creating a bigger discount to the present value of future profits.

However, with a recession on the horizon, it’s not that simple. Firms whose products are at risk of falling costs, such as retailers, leisure providers and homebuilders, are seen as most susceptible to slowing economies, while those with better pricing power, such as consumer staples and healthcare, trade at large premiums for the sector. broader market as investors flock to safer havens.

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“There is a recalibration of inflation and that has serious and important consequences from a stock market perspective,” said Wouter Sturkenboom, chief investment strategist for EMEA and APAC at Northern Trust. “Investors are looking at this world through a new lens and it’s more focused on inflation and more focused on risk reduction,” he said in an interview.

In these circumstances, any hint of lower prices is likely to be taken positively. “It’s the direction of inflation that matters for stock prices,” said the Liberum Capital Ltd. strategist. Joachim Klement. “Every decline in inflation reduces some of the cost pressures that businesses face.”

Here’s a look at how Europe’s inflation crisis is playing out across sectors.

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Merchandise

Energy is the only European sector in the green this year, boosted by the rise in oil prices. And analysts are not ruling out further gains. Credit Suisse Group AG lifted price targets across the sector on Friday, citing top picks Shell Plc and TotalEnergies SE as stocks that could further outperform.

Meanwhile, renewable stocks are seen as long-term winners as countries invest heavily to reduce dependence on fossil fuels and imports from Russia.

For mining stocks, the outlook is less certain. While they tend to outperform during periods of high inflation, gains may be dampened by concerns over China’s demand for metals due to the country’s housing slump and the economic impact of its Covid-0 policy, according to Morgan Stanley analysts, including Alain Gabriel.

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banks

The sector, which belongs to the value category, is shaping up to be an inflation winner, showing the best performance of industrial groups in Europe this month. Higher interest rates to cool prices mean higher loan profits.

Bank of America Corp. analyst Alastair Ryan says the sector could see an 88 billion euro ($88 billion) increase in net interest income from the expected rate hikes . “This big increase in earnings is why we remain bullish on banks in the face of problems elsewhere,” he wrote in a note.

On the other hand, lenders face concerns about the volume of bad debt that could materialize during the looming recession, which may explain why rising bond yields haven’t provided a bigger boost than they have had

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Basic articles

Pricing power is key during inflationary periods. Companies that are able to protect their margins as costs rise, such as consumer staples, health care and groceries, are likely to be favored, says James Athey, chief investment officer at Abrdn Plc.

However, inflation also carries risks for European commodities. According to Morgan Stanley analysts, including Pinar Ergun, consumers in the region are more vulnerable to rising living costs than elsewhere in the world due to an unstable geopolitical context and the energy crisis.

“Investors appreciate the sector’s defensiveness, but at current valuation levels, many opportunities have become prohibitive,” they said.

Retail sale

Retailers are the worst-performing industrial group in Europe this year, and inflation has a lot to do with it. With budgets squeezed by the cost of everything from food to energy to mortgages, consumers don’t have as much to buy, while rising costs are also eating into profitability.

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It’s “a bleak picture for retail stocks,” said Charles Hepworth, chief investment officer at GAM Investments. “Disposable incomes for most consumers have been massively reduced, and downward trade substitutions in cheaper brands are not the best boost for any hope of a consumer-led recovery,” he wrote.

Luxury clothing can be one of the safest bets. Sophie Lund-Yates, an analyst at Hargreaves Lansdown Plc, favors companies such as LVMH, with customers of its Louis Vuitton brand “less likely to be hurt by falling real wages.”

technology

As a core part of the growth category, tech stocks have led the decline in global equities this year due to rising bond yields. And despite its underperformance, the sector “remains very expensive,” according to Barclays Plc strategist Emmanuel Cau.

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“With growing signs of lower demand coming from semiconductors, demand destruction may be the next shoe to drop,” Cau said.

Construction, Real Estate

Construction faces a precarious outlook. The industry is “waiting anxiously to see how the twin headwinds of squeezed budgets and rising rates will affect demand,” says Danni Hewson, analyst at AJ Bell. Builders such as Barratt Developments Plc and Persimmon Plc have fallen more than 40% this year, while Hewson says suppliers to the sector could also be at risk. HeidelbergCement AG and Travis Perkins Plc are among the stocks to watch.

Meanwhile, analyst at Goldman Sachs Group Inc. Jonathan Kownator warned of escalating macroeconomic risks to commercial real estate on Friday, downgrading Land Securities Group Plc, British Land Co Plc and Aroundtown SA. The sector has a very high negative correlation with bond yields, he said.