Surging commodity prices, supply component disruptions and faster than expected tightening in labour market conditions across many economies, including Australia, are now causing investor concerns around rising input cost pressures and the likely negative impact this might have on corporate profit margins, earnings and ultimately the ability of the equity market to move higher.

The potential for higher inflation to begin seeping into the corporate cost base should come as no surprise to anyone who has been watching the narrative around broader inflationary pressures.

Extraordinary fiscal and monetary policy settings around the world, on top of a faster than expected demand and activity rebound has seen sharp increases in commodity prices, rising borrowing costs and labour tightness as a result of border controls.

One quarter of the companies presenting at the recent Macquarie conference highlighted the impact of input cost pressures and how it is taking some gloss off the strong economic and earnings rebound expected for the next 12 months.

Traditionally rising input costs can be problematic for margins and corporate profitability, but at this stage we see it as something which is transitory and stock and sector specific, rather than something which will prompt a broad based sell off across the Australian equity market (as some have predicted).

The factors at play

To explore this further, a number of factors should be considered.

Large stimulus packages designed to offset the pandemic have been the key contributing factor to input price pressures, particularly within the commodity space. This means that the supply side response and a tapering of demand could see much of the price increases to be transitory rather than permanent.

Rising input costs – predominantly raw materials and labour – are not going to have a uniform impact on all businesses and its ultimate impact will depend on the unique circumstances of each company.

“Stay invested and stay active.”

Corporates in Australia have been running quite lean on the cost side, courtesy of a decade of cost cutting due to weak demand and lack of investment. We think there is some capacity to absorb minor and transitory cost increases without a major impact on earnings outlook.

Much of the cost increases that corporates face today are cyclical and are the result of an improving economic backdrop. Historical evidence suggests that rising input costs are closely correlated with improving margins (rather than declining margins) because of companies’ ability to pass on costs increases to the final consumer in a strong demand environment.

Australian corporates are underleveraged and while rising borrowing costs may impact earnings, debt burdens remain low, especially in comparison to the US where low borrowing rates have driven a raft of debt financed stock buybacks.

A large part of the Australian equity market is a positive beneficiary of rising commodity prices. The resources sector comprises nearly one-quarter of the Australian market capitalisation. A bull market in commodity prices has the potential to create a significant boost to overall earnings as well as provide strong sector leadership for the equity market even if it is having the opposite effect on some stocks and sectors.

It would be unusual for cost pressure to dominate broader earnings tailwinds at this stage of the economic recovery and it may simply be a case where corporates choose to absorb cost increases in an effort to gain market share.

Bull market intact

While we remain vigilant for further cost pressures as well as signs that these might be broadening out, we don’t see this as something which undermines the equity bull market.

Australia is currently in the midst of the strongest earnings upgrade cycle in two decades as analysts chase an economic recovery which has surprised substantially and consistently on the upside. Leading activity indicators signal that this trend is likely to continue well into the second half of the year.

In addition, the recent 2021/22 Federal Budget was pro-growth and highly expansionary. Combined with the RBA’s commitment to lower interest rates, this should prove to be a strong tailwind for the equity market irrespective of rising cost pressures (though it may act as a headwind for some areas of the market).

This is further reason to favour active investors for their ability to cherry pick the best companies to thrive in the current environment.

Stay invested and stay active.

This article was originally posted on The Australian Financial Review here.

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