Seeking value despite inflation

Equity Insights offers research and perspectives from Putnam’s equity team on market trends and opportunities.

(updated 11/2/2022)

Investors today are encountering challenges they haven’t seen in decades. In March, the U.S. Federal Reserve began raising interest rates, marking the start of its most rapid interval of rate increases since the early 1980s, according to The Wall Street Journal. The Fed’s increase on November 2 brought the federal funds rate to a range of 3.75%–4.00%. This, of course, is an effort to tame inflation, which has reached 40-year highs.

When it comes to inflation, as with any macroeconomic challenge, Putnam’s analysts and portfolio managers benefit from their active management approach. They remain focused on stock selection and deep fundamental research to understand how businesses are dealing with inflation, and which companies may be best positioned to weather its impact. Analysts across our global equity research team are gaining insights from their ongoing discussions with company management teams and from their stress-test analyses of earnings and balance sheets.

We talked to members of our equity team for insights on inflation and its impact on investors.

Jacquelyne Cavanaugh
Portfolio Manager, Analyst
Putnam Focused Equity Fund and Putnam Research Fund
Sector: Global financials
jackie cavenaugh

Inflation continues to run hot relative to where the Federal Reserve would like to see it, and certainly relative to the Fed’s target of 2% inflation. The main challenge for the Fed is that the U.S. economy is very consumer driven. Consumer spending accounts for almost 70% of U.S. gross domestic product, and the consumer remains extremely healthy despite multiple interest-rate hikes in 2022.

In the third quarter, credit and debit card spending on travel rose 20%, food spending gained 10%, and spending on services rose 9%, according to data from Bank of America. Also, cash deposits and savings levels remained high for consumers at all income levels. We’re seeing high rates of spending, but savings accounts have been replenished. We still have a strong job market, and many people have not yet spent the stimulus cash that went into the system during the pandemic.

Inflation is typically not great for the economy or equity markets, but this could be a compelling environment for banks.

The consumer is not going to roll over — and cause the Fed to pause rate hikes — as quickly as many may have hoped. I think inflation has probably peaked, but the Fed may have to raise rates further, and keep them high longer, to bring inflation down. Many market observers are anticipating rate hikes through April 2023, and then rate cuts by November 2023. In my view, that’s too soon for Fed easing, given the current strength in the consumer sector.

Inflation is typically not great for the economy or equity markets, but this could be a compelling environment for banks, at least for a while. I believe we could see substantial earnings growth for banks, as higher interest rates bring higher net interest margins. Along with accelerating revenue and a very low cost of deposits for banks, credit cost pressures are minimal. Credit losses were already low before the pandemic, and they’re even lower now. The only area in which banks are feeling a bit challenged is labor — that is, the need to pay higher wages to recruit and retain employees. However, I don’t believe this outweighs the many tailwinds.

Of course, as with investing in any industry, a bit of caution is warranted. Eventually, if the Fed is successful, we’ll see higher unemployment and higher credit losses, and those cash balances and credit lines will come down. If we start to see credit stress emerge, we may lighten our exposure to financials broadly. However, I do expect a constructive environment for banks for at least the next several quarters, if not through 2023.

Joshua Fillman
Portfolio Manager, Analyst
Putnam Focused Equity Fund
Sectors: U.S. consumer and U.S. industrials
Joshua Fillman

Consumers are certainly feeling the pressures of inflation, which presents considerable challenges for both family budgets and business profitability. However, environments like this can be exciting for stock pickers like us who are focused on fundamental research.

In less-volatile environments, much of the equity market tends to move together, with less dispersion in the performance of individual stocks. Stocks will advance at the same pace regardless of the companies’ fundamental strengths or weaknesses. But in difficult markets like today, with a rapidly evolving macroeconomic backdrop, we see more differentiation in performance. Without rigorous fundamental research, it is much more challenging to find the companies that can outperform their peers.

How a business is affected by inflation depends on many factors, including what sector it’s in, what its input costs are, and how differentiated its products are. Our analysis of two consumer product companies — Clorox and Coca-Cola — provides an example. We looked at how much each company would have to raise its prices to keep profits at the same level as the previous year. We found that, in today’s inflationary environment, Clorox would have to raise its prices by 10%, while Coca-Cola would only need to raise prices by 2%.

Environments like this can be exciting for stock pickers like us who are focused on fundamental research.

This is because their business models are quite different. Clorox manufactures items with materials that are heavily reliant on oil and oil derivatives, which have skyrocketed in cost. Also, Clorox employs a significant amount of labor, and its distribution requires considerable transportation costs, which has put the business under tremendous inflationary pressure. Coca-Cola, on the other hand, largely produces the concentrated syrup for all of its bottling partners, who then produce the soft drink. Coca-Cola itself does relatively little bottling. This means that Coca-Cola does not carry the same commodity exposure or significant transportation expense as Clorox, and it has relatively low labor costs. Thus the burden of inflation is much less severe for Coca-Cola than for Clorox and many other consumer companies.

While inflation has been onerous on the U.S. consumer, the problem is not isolated to the United States. Inflation has been a global issue this year. This creates other factors to consider when choosing businesses for an investment portfolio. A byproduct of global inflation has been a strengthening U.S. dollar relative to other currencies. This has implications for companies, like Coca-Cola, that are more global in their reach, and we must consider this in our analysis. But the bottom line is that inflationary environments often create more opportunity, with our rigorous analysis, to yield differentiated stock ideas.

To conduct our analysis, we dig deep into the moving pieces of every company’s financials and identify those whose business models better equip them to navigate inflation and other macroeconomic challenges. We cross-check our work by testing our assumptions with CEOs and CFOs of companies, as well as their customers and suppliers, and define the range of possible outcomes while pinpointing the most likely.

Lauren DeMore, CFA
Portfolio Manager
Putnam Large Cap Value Fund
Lauren Demore

We’ve clearly seen that inflation can have wide-ranging effects — from the labor markets to transportation to raw materials and beyond. Surging inflation has broad implications for the global economy. Inflation is likely to stay elevated at least through the end of 2022, and possibly well into next year as the eventual softening in housing prices takes considerable time to bleed into the inflation data. As portfolio managers, we don’t try to predict the duration or magnitude of inflationary forces. Instead, we focus on how inflation might impact the profitability of the companies we own. Many sectors in our value universe, such as health care, are relatively immune to inflationary pressures. However, companies in some sectors are quite challenged. For example, businesses in consumer staples are facing rising input costs, and these firms will likely try to pass on higher prices to their customers.

We tend to see pricing power in companies with concentrated end markets.

We aim to find companies that have pricing power — the ability to raise prices to cover their increased costs without negatively impacting demand. We tend to see pricing power in companies with concentrated end markets — think Coca-Cola or PepsiCo — but for larger discretionary products like furniture and electronics, it depends on whether consumers are willing and able to spend in this inflationary climate. We have also seen retailers cutting prices to move their inventory. We’re mindful of other instances where pricing power will be challenged. For example, we’ve seen banks reporting higher levels of wage inflation. This tends to be a cost that is not easy to pass on, especially in an industry as competitive as banking.

Through careful portfolio construction and stress testing, we seek to manage our portfolios’ sensitivity to inflation as well as to interest-rate and bond-yield movements. With our risk management process, we work to keep the portfolio from meaningfully underperforming in a rising-rate environment. We also seek to manage interest-rate risk by maintaining a mix of holdings with varying interest-rate sensitivity.

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Data sources: The Wall Street Journal, Nick Timiraos, October 10, 2022. Bank of America Q3 Earnings Presentation, pages 4 and 5.

Holdings as of 9/30/22: Putnam Focused Equity Fund: Clorox and Coca-Cola were not held. Putnam Large Cap Value Fund: Coca-Cola (1.06%); PepsiCo was not held.

The views and opinions expressed are those of the authors, are subject to change with market conditions, and are not meant as investment advice.

Our investment techniques, analyses, and judgments may not produce the outcome we intend. The investments we select for the fund may not perform as well as other securities that we do not select for the fund. We, or the fund's other service providers, may experience disruptions or operating errors that could have a negative effect on the fund. You can lose money by investing in the fund.