Inflation has been a hot topic, and with good reason. Measures of inflation over the last several months have been nothing short of historic. However, recent data seem to indicate some cooling, with many commodities well off their highs, the Chinese economy and markets in flux, the COVID-19 Delta variant impacting economic activity, and geopolitical tensions rising. There seems to be no shortage of factors that could lead to slowdown or moderation in inflation. Does this mean investors can shrug off inflation and turn their focus elsewhere? We believe that may be premature and that it’s still prudent to consider the impacts inflation could have on various asset classes.
What sets the current environment apart is the broad-based nature of input-cost inflation, spanning raw materials, logistics/transportation, and labour, as well as shortages of intermediate goods such as semiconductors. This is coupled with pent-up demand as economies reopen and consumers are flush with savings, giving firms a rare degree of pricing power.
Our corporate credit team has been monitoring earnings calls, management commentary, and industry data to assess the ongoing importance of inflation and potential implications for the US high yield corporate bond market. Through this analysis, a few things have become apparent:
- Even if inflation moderates, the impact of the sharp upturn in the last several months is likely to be felt for several more months and even quarters.
- Certain sectors are likely to experience greater impacts from input-cost inflation than others.
- Overall, US high yield corporate credit should weather inflation reasonably well in most scenarios.
Let’s explore each of these points in a bit more detail.
The recent uptick in inflation will likely continue to be felt in coming quarters. Based on management commentary on second quarter 2021 earnings calls, not only have most input cost pressures not subsided, but in many cases have worsened from earlier in the year. For example, several auto companies indicated greater-than-expected hits from semiconductor shortages, higher freight and logistics costs, and elevated raw materials prices. Semiconductor shortages that were initially expected to abate over the second half of the year are now expected to remain challenging, with supply constraints likely extending into 2022. In the chemicals sector, the lingering effects of winter storm Uri continue to constrain the availability of plastics, used as an intermediate good in a wide range of products, while the impact of Hurricane Ida threatens to further exacerbate the situation.
Meanwhile, shipping costs continue to climb on domestic equipment and labour shortages, as well as international port shutdowns and labour shortages due to COVID-19 infections that have resulted in delayed and dislocated ships and containers. While the domestic labour shortage may moderate over the near term as unemployment benefits expire and children return to classrooms, shipping and logistics costs are likely to remain very elevated at least through the fourth quarter of this year. This reflects demand as retailers attempt to replenish already-low inventories and stock adequately for the holidays, combined with the continuing effects of the international disruptions.
Companies are leaning heavily on pricing, in addition to productivity and cost savings measures, to blunt the impact to margins. In some industries, companies have contracts in place that allow them to pass along increases in input costs to their customers, but often these price increases come with a lag. Other companies have disclosed plans to increase prices over multiple months and/or quarters so as not to create problems for customers or risk shocking demand. On second-quarter earnings calls, many companies talked of having already taken one or more rounds of price increases, with some committing to further price increases and some saying they’ll take additional pricing as needed. Such price increases will travel down the supply chain for at least the next quarter or two, with some actions extending into 2022.
Certain sectors are likely to experience greater impacts from input-cost inflation than others. In order to assess how various high yield sectors are likely to fare in the current period of inflation, we considered the following:
- Input-Cost Inflation: How impacted a given industry is by inflationary pressures in raw materials, transportation and labour, as well as shortages of intermediate goods such as semiconductors.
- Pricing Power: How much issuers in a given industry are likely to be able to offset higher input costs through higher prices.
- Impact to Earnings: What impact the net of input-cost inflation and higher pricing are likely to have on profitability. This takes into account the degree of pricing power as well as potential timing lags for raising prices to cover higher input costs.
- Repricing Vulnerability: How vulnerable a given sector is to repricing of bonds due to impact on earnings from higher input-cost inflation, taking into account current trading levels.
This analysis shows that certain sectors such as autos, consumer products, food & beverage, and retail are likely at elevated risk of a negative repricing of bonds in those sectors. Conversely, sectors such as energy exploration & production and metals & mining are expected to benefit from higher commodity prices and have greater upside than downside repricing potential under this framework.
Overall, US high yield corporate credit should weather inflation reasonably well in most scenarios.
Assessing each industry sector using this methodology and then taking into account the weighting in the ICE BofA US High Yield Constrained Index, we found that over half of the index is in industries that have low repricing vulnerability, and a further 20% is in industries that would benefit from higher commodity prices.1 Only about 25% of the index is in industries that are at elevated risk of repricing from inflationary pressures, with only a small subset of these sectors at high potential risk of repricing. It should also be noted that some of these industries may benefit from other offsets such as higher volumes that could moderate the repricing risk from input cost inflation.
Thus, we believe that US high yield corporate bonds overall are likely to face only modest downside from prospective impacts of input-cost inflation and shortages on credit fundamentals, although we believe there are advantages that can be gained from careful industry weighting and credit selection.
One also needs to consider how the asset class would be impacted by a rise in Treasury yields in response to higher-than-expected inflation readings. Here, we think that US high yield spreads have room to compress to absorb a measured rise in Treasury yields, considering that spreads are still wide of historic lows across ratings tiers and the default rate is likely to remain very low at least through 2022.
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