UBS says this 4-part inflation playbook will help investors profit now and in the market's next phase – and shares how to track the threat of higher prices in real time
- Keith Parker at UBS says investors who play a strict “reflation” theme are missing out.
- He says inflation is approaching a risky level and recommends focusing on “strong pricing power.”
- Parker breaks down the 4 different ways investors can employ a pricing power investment strategy.
- See more stories on Insider’s business page.
UBS is warning investors that worrying about inflation or focusing on a basic reflation trade aren’t the best ways to get ahead in today’s stock market.
While some investors go risk-off and others take a risk-on approach, UBS strategist Keith Parker says investors need to find the dividing lines between the firms that can handle inflation pressures and those that will fall short.
“We expect the pace of outperformance for the reflation theme to slow in the coming months, but accelerate for stocks with strong pricing power vs weak,” he wrote in a note to clients. “We believe stocks which have greater ability to pass on higher prices should be better positioned to outperform.”
The combination of snarled supply lines, worker shortages, and a quick economic rebound have created spikes in prices and inflation, and that’s contributing to the broad reflation trade today. But as the pace of month-to-month inflation increases slows down, it will be better to take another approach.
“A number of factors make the strong vs weak pricing power trade attractive now: it’s working across most sectors, it’s relatively cheap, has better pricing trends and much lower margin expectations for Q2,” Parker said.
Pricing power is simply the ability for a company to increase its prices in order to offset higher costs. Parker says the biggest winners going forward combine that power with margin momentum, which evaluates how bullish analysts are about the companies’ profit margins and sales growth.
Meanwhile, less pricing power and higher input cost exposure are signs of trouble for other companies.
“After inflation jumps, companies with strong pricing power should notably outperform weak firms based on history,” he wrote in a note to clients. “Strong pricing power stocks have typically started to outperform with a slight lag following an acceleration in inflation above 2%.”
Parker focused on industries where standard inflation measures – producer price indexes and consumer price indexes – are up 10%, on average, compared to one year ago. He says that the stocks experiencing those big increases have historically left their peers with lower price leverage in the dust.
He argues that that’s an urgent theme right now because the inflation that’s happening today is the result of supply problems, not increased demand. Parker says supply-related inflation is usually a bigger problem than inflation caused by great demand.
“The market is underpricing some of the risks around rising input costs and there are opportunities to move up the quality spectrum,” he said.
Where are the best targets? Parker says the strong pricing power stocks within the healthcare, materials, communication service, and consumer discretionary sectors have outperformed by the widest margins in higher-inflation environments.
Overall, Parker says that investing in large cap stocks and avoiding banking, energy, and utility companies magnifies that advantage.
Parker adds that the price power winners have even more potential right now than their business models would indicate because a lot of investors are misreading the situation. He says that instead of buying companies with pricing power, much of Wall Street is betting that companies with less of that power will expand their margins.
He says that’s the opposite of what’s likely to happen. That leaves these stocks looking cheap relative to their future earnings.
“We believe consensus is underestimating the strength of margins for strong pricing power firms and overestimating the resilience of margins for weak pricing power companies,” he said. “Strong pricing power firms have delivered stronger margin growth historically.”
Parker says supply chains will get healthier and pent-up demand will eventually slacken, and as a result, inflation pressures should ease later in the year. That would help corporate profit margins and stocks. But investors would be well-advised to watch 10-year Treasury breakevens in case they give off a signal that inflation is becoming a problem.
“We believe the tipping point at which rising inflation becomes bad for the equity market is when the 10y breakeven moves above 2.5%,” he said. “It is at this point, where cost pressures are more intense, and rising inflation begins to squeeze consumer spending.”