Inflation, interest rates and AVENIR Funds
For 20 years, deflationary forces (globalization, technological innovations) have dominated inflationary forces. Now the pendulum is swinging back with deflationary forces fading (globalization) and inflationary forces emerging (rising wages, relocation, expansive fiscal policies, high investment needs).
The acceleration of inflation in the world
For 20 years, deflationary forces (globalization, technological innovations) have dominated inflationary forces. Now the pendulum is swinging back with deflationary forces fading (globalization) and inflationary forces emerging (rising wages, relocation, expansive fiscal policies, high investment needs). Since the arrival of the Covid-19 vaccine at the beginning of November 2020, companies have been facing supply bottlenecks, rising energy and commodity prices, a tightening labor market in the United States in particular and a strong recovery in demand.
The consumer price index (CPI) and the producer price index (PPI) are thus rising sharply. In the United States, the CPI and PPI have been rising steadily each month since November 2020. Year-on-year, the CPI and PPI are at their highest levels since December 1990 for the CPI and 1980 for the PPI.
Title: The evolution of CPI and PPI in the US and Europe since October 2011.
Source : Bloomberg (au 26/10/2021)
The sources of this inflationary acceleration
Since the first lockdown of 2020, we, at Groupama Asset Management have believed that inflation in the developed countries would emerge from its lethargy and return to higher levels as long as the economies reopened. We did not believe that inflation would only be a short-term phenomenon, because in addition to short-term drivers, there are medium- and long-term factors.
Short term Factor :
- Rising commodity prices
In recent weeks, most commodities have reached their highest levels in history. After several confinements, the strong recovery in demand combined with the explosion of the electric vehicle market has been met with a limited supply due to the closure of several nuclear and coal-fired power plants, low gas reserves in Europe and reduced metal production in China. The price surge was then reflected in many sectors such as construction, industry and the automotive industry (which is also suffering from the shortage of electronic chips).
Title : The Bloomberg Commodity Price Index reached its highest level in history (as of 26/10/2021)
- Bottlenecks in supply chains
Due to several factory closures and outdated seaports, global supply chains have been permanently affected by the health crisis, especially in emerging countries. The confinements have indeed led to the closure of factories, blocking sectors such as textiles or semi-conductors for example. For the latter, these shutdowns have had a snowball effect on car assembly plants in Europe and the United States.
Medium-term factors: catch-up needs
The exceptional savings accumulated by households over 2020 and even 2021 are creating a consumption “boom” today, while supply is unable to keep up with exceptionally low inventories. Labor shortages, as in the United States, are reinforcing this imbalance.
- Labor shortages
In the United States, many indicators suggest a labor shortage. For example, the number of unemployed workers is now lower than the number of job offers. Thus, these labor supply and demand indicators suggest that the labor market should quickly return to “full employment”, which corresponds to an unemployment rate of between 3.5% and 4.0%.
In the Eurozone, labor shortages are increasing in industry, particularly in Germany. However, these shortages are not generating pressure on wages at this stage.
- The rise in real estate prices
Older home prices have been on the rise since the second quarter of 2020 in many parts of the world, particularly in the Anglo-Saxon and Northern European countries, which have seen an increase of over 10% this year.
This increase in real estate prices can be explained firstly by the imbalance between supply (constrained construction activity and insufficient supply in view of population growth) and demand (lower interest rates, increased savings). Secondly, the Anglo-Saxon countries, where the increases are the strongest, are the countries that have had the most budgetary support.
- In addition, many budgetary plans are being deployed, often with a social focus as is in part the Biden Plan, and will continue to have an effect in 2022
Long-term factors: considerable investment needs
The coronavirus crisis has triggered or reinforced themes that will have an impact on prices. Infrastructure spending, environmental transition, relocation of some production tools are some of the needs that will support prices.
Our vision on interest rates
- Investors and Central Banks are coming to terms with the idea of a new inflation regime for longer than imagined
Faced with the persistence of the above-mentioned medium-term factors and the strength of short-term factors, investors are gradually adjusting their interest rate exposure downwards.
Inflationary risks are also putting central banks in an uncomfortable position, as they are forced to gradually withdraw their support for the economy in the face of a surge in inflation that is not abating, thereby weakening the bond markets. They recognize that inflation figures are holding at high levels for longer than expected, but believe that these effects remain transitory. In this respect, the gradual reduction of purchasing programs is taking shape in the months to come. Hikes in key interest rates should come in a second phase with a certain parsimony on the part of the Governors.
The steepening of the yield curves (long-term rates rising faster than short-term rates) observed recently is boosting lending margins and thus the profits of the banking sector (which generally borrows short-term and lends long-term).
- Rates expected to continue to rise, but much of the way is done
Aware of this new inflation dynamic expected by our macroeconomists from 2020 onwards, Groupama Asset Management’s bond managers have had a bullish overall view of both rates and inflation expectations since the start of the year. They believe that the upward movement should continue with a bias towards the steepening of the yield curves.
However, they do not expect a bond crash, anticipating a German 10-year rate of 0.20% (versus -0.11% at the end of October 2021) and a US 10-year rate of 2.40% (versus 1.55% at the end of October).
 Source : Bloomberg
AVENIR funds : A resilient dynamic
In our opinion, the potential operating performance of the companies in the Avenir range of portfolios should remain very solid over the medium term in a context of a recovery in inflation that is more sustained than in recent years but remains under control.
Pricing Power”, an important advantage in this context.
The companies in the portfolio have a strong ability to increase the selling prices of their products/services (“pricing power”). This once again justifies our demand for quality across the board. Our companies are generally located in high value-added niches, they are generally market leaders and we expect them to be strategic for their customers. The combination of these three factors has several favorable consequences.
Our companies are often positioned as premium suppliers: price is only a very secondary feature of their offer, and they are generally 15% to 30% more expensive than their competitors (in the manner of Mercedes vis-à-vis generalist manufacturers).
- Our companies are strategic suppliers but represent only a small fraction of the customer’s costs. Therefore, their customers do not see the point of bypassing them. By analogy, if a gold digger has made his fortune using premium shovels that allow him to dig 20% more earth for the same effort, he will not change his shovel brand for a few percent price increase that will only cost him a few euros.
- In 86% of the cases, our companies are the leaders in their market, and therefore set the pace: they decide first when and by how much to raise prices, followed by the secondary players (“price takers”). Our companies are thus able to better control their margins.
- The combination of these factors is effective as it allows our companies to produce high operating margins above 18% for each of the 3 funds in the Avenir range.
The positioning of our portfolio companies in the context of a strong recovery in demand.
- The strong positioning of portfolio companies generally enables them to occupy a position of choice vis-à-vis their suppliers. In a context of severe shortages of certain products, this advantage is significant: it ensures that the company will be able to meet its customers’ demand. And in fact, we do not currently see any production breakdowns among our companies. This mastery of the supply chain reinforces their brand image and confidence, and therefore their strategic positioning on the long term towards their customers.
- Our portfolio companies are able to select the “best” contracts in a context of strong demand. The current inflation comes not only from a disorganization of supply after the long period of confinement we experienced, but also from a strong demand linked to the recovery of the economy. The companies in our portfolios, positioned according to our analysis on very solid underlying trends, are obviously also benefiting from this very buoyant environment. Thus, as we emerge from the health crisis, we are witnessing a renewed movement towards the digitalization of our societies and increased needs in our healthcare systems, which benefits to a large extent the Avenir portfolios, which are heavily exposed to the information technology and medical technology sectors. Faced with a demand that exceeds their production capacity, portfolio companies have the opportunity to select the most attractive contracts. And we note that the price increases obtained by certain portfolio companies are often higher than what would be justified by the increase in their costs alone. This is because 1/ customers have high expectations for the products/services of portfolio companies and are therefore willing to accept significant price increases to ensure delivery and 2/ customers are not really aware of the impact of raw material price increases on the cost of the final product and are therefore not in a position to negotiate properly.
- Some of the players in which we are invested have long supply contracts with regulated prices with some of their suppliers, which also allows them to smooth out the effect of certain price increases over time. In addition, management is always looking for ways to improve their performance, whether through the selection of additional suppliers, the implementation of strategic contracts to obtain better visibility on their supply, or optimization and cost reduction plans. Here again, we believe that fundamental analysis plays a key role in the portfolio’s potential performance. Our assessment of the companies’ management, their estimated ability to implement their strategic vision and to cope with unforeseen situations are key factors in our decision to invest in the stock for the long term.
- The portfolio companies also benefit from the quality of their human capital management, in a period when talent is scarce and increasingly expensive. The companies’ good reputations and positioning in high-growth markets allow them to attract new talent and keep turnover (“churn”) low in an increasingly competitive market. In addition, their continued investment in automation allows them to generate growth without resorting to massive hiring. The result is an improved ability to keep up with market demand and a positive effect of growth on profitability.
Of course, accelerating inflation can lead to a time lag between commodity inflation and rising corporate prices. This is often only a matter of a few quarters, but can cause some volatility in the evolution of company prices.
We believe that any such temporary margin squeeze would be fairly limited in its impact on the operating performance of companies in the Avenir portfolios. For example, we estimate that the average gross margin for Groupama Avenir Euro is 60.3% (63.0% for G Fund Avenir Europe, 60.7% for Avenir Small Cap) and the operating margin is 18.3% (21.9% for G Fund Avenir Europe, 18.6% for G Fund Avenir Small Cap). As a result, a possible temporary loss of 2 margin points due to a delay in taking into account cost increases (raw materials, energy, personnel costs, etc.) would result in a decline, all else being equal, of around 9% in the value of operating income. If the portfolio had been invested in companies of more average quality and producing margins of only 9%, this would have resulted in a double impact! It should be remembered that this hypothetical loss would in any case be temporary and quickly recouped by price increases and the companies’ optimization efforts. Finally, the growth rate of the companies in the portfolio is around 20% per year, which allows them to quickly absorb such an impact.
A few examples to illustrate the positive dynamics that the portfolio is currently experiencing:
- KION is a supplier of logistics solutions (SCS division) and forklift trucks (ITS division). In the logistics solutions business, sales are made in the form of contractual projects with supply cost clauses that are automatically revalued in the event of inflation. Forklifts (ITS division) are subject to an annual price revaluation. Exceptionally this year, the company made an additional exceptional price increase on June 30. The company was also able to cushion the effect of rising raw material prices through multi-year contracts with its main suppliers. Finally, Kion is protected by the very strong demand (order book up +57% in Q3 2021) caused by warehouse automation and by the very good positioning of its offer, which allowed it to revise its annual outlook upwards on October 26.
- SOITEC specializes in the supply of very high performance wafers for the semiconductor industry. It sources silicon wafers and improves their characteristics for its customers. SOITEC has managed to meet its delivery commitments in a tense environment and to more than offset the increase in wafer prices. Driven by strong demand and industrial productivity improvements, the company has raised its EBITDA margin guidance for the current year from 30-32% to 32-34%.
- SIXT is a company specialized in the rental of high-end vehicles. Thanks to its very good relations with car manufacturers, it has managed to obtain new vehicles in a difficult context in a satisfactory manner. It has also reacted to the unprecedented shortage by forging links with car manufacturers outside its traditional scope, such as BMW and Mercedes, in order to diversify its supplies. Thanks also to its extensive geographical footprint (Sixt was able to buy many airport concessions in the United States at low cost at the time of the health crisis), the company has benefited fully from the increase in rental rates since the beginning of the year. As a result, it has been able to significantly revise its earnings estimates for the current year, by +5% on revenues and especially by +30% on pre-tax earnings.
Performance tables for Groupama Avenir Euro (M share class) and G Fund Avenir Europe (IC share class) as of 29/10/2021.
Title : Performance tables for Groupama Avenir Euro (M) as of 29/10/2021.
Source : Bloomberg, Groupama AM
Title : Performance tables for G Fund Avenir Europe (Part IC) as of 29/10/2021.
Source : Bloomberg, Groupama AM
Our outlook for stock picking and the quality of the companies held in the Groupama Avenir Euro, G Fund Avenir Europe and G Fund Avenir Small Cap portfolios.
As can be seen from the few examples we described above, despite the current acceleration in inflation, we are very confident in our companies and their ability to raise their prices to reflect inflation in raw materials and general costs. While investor flows may be attracted in the short term to sectors that benefit directly from inflation or rising interest rates, such as commodities or banks, our portfolio holdings should also emerge positively from the current inflationary recovery.
We are therefore convinced that structural trends will continue to enhance the value of the quality companies in our portfolios. The major structural dynamics of the market are there and the companies that participate in these developments will continue to benefit from them (needs in medical innovation, digital innovation, e-commerce and automated logistics, industry 4.0.)
We are convinced of the quality of the companies in our portfolio and their ability to maintain their strong operational growth momentum. In the medium term, the market will remain very selective and we must continue to focus on the “best players”. More than ever, we believe that our stocks should continue to show strong growth prospects and gain market share, thereby strengthening their competitive advantage.
Completed November 4, 2021.
The main fund risks are:
– Equity risk: Variation in share values can have a positive or negative impact on the net asset value of the fund.
– Equity risk : A variation in equity quotation could positively or negatively affect the fund’s net asset value
– Capital risk : It exists the possibility that the invested capital could not be totally returned
Small/mid cap market risk: On the mid cap markets, volume of traded securities is reduced, market movements are more pronounced downward wise, and faster than in the case of large caps
– Liquidity risk: Due to the exposure to small and mid capitalisation stocks, which could present a limited level of floating capital
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