January 13, 2017 / 3:31 PM / in 2 years

INVESTMENT FOCUS-Return of inflation puts focus on pricing power

* Pricing power key for investors faced with rising inflation

* Commodity prices have recovered sharply

* Food prices: reut.rs/2jLZacs

* Euro area inflation: reut.rs/2jM8e1e

* Margins under pressure: reut.rs/2inrgWr

By Vikram Subhedar and Kit Rees

LONDON, Jan 13 (Reuters) - Rising prices of commodities from vanilla to oil are stoking inflation expectations and turning investor attention to profit margins at companies, especially in consumption-related industries, that may struggle to pass on rising costs to consumers.

The so-called “reflation trade,” which has lifted U.S. and UK stock markets to record highs, began in earnest last quarter, as bond yields rose on bets that more spending on infrastructure would spur economic growth.

A recovery in metals prices and the rallies in agricultural commodities, however, mean that input costs for a range of European companies are rising for the first time in three years. That leaves sections of the market at risk, especially with valuations now above their long-term averages.

In the UK, a slide in sterling since last June’s Brexit referendum is expected to hit consumer spending this year, putting further pressure on margins.

That leaves companies in Europe’s retail, travel and leisure sectors among those most vulnerable, analysts and investors say. Intense competition in a bid to keep customers will make it harder for them to raise prices and absorb higher costs.

“The closer you are to the consumer, then you are in a real squeeze situation,” said Trevor Greetham, head of multi-asset at Royal London Asset Management, drawing parallels with a similar situation in 1994 when commodity prices surged.

“The closer you are to the shovels, the closer you are to the commodity end, you can pass it on. If you’re a mining company, or an oil producer, this is what you do, you pass on price rises,” Greetham said.


Upbeat results this week from UK supermarkets and retailers sent shares soaring. The numbers caught investors off guard, though the outlook remains tough, according to some of the top-ranked analysts covering the sectors .

Bank of America Merrill Lynch analysts, led by Angus Tweedie, expect the slide in sterling to squeeze UK consumer budgets in 2017 and also push costs higher, particularly for apparel retailers sourcing clothes from abroad.

Next week, sales updates from the likes of H&M, Burberry and JD Wetherspoon will keep the European retail sector in focus.

Analysts have consistently cut forecasts for gross margins for several consumer-focused industries in Europe over the past few years. Autos, travel and tourism and restaurants and bars saw the sharpest cuts, according to Thomson Reuters data. More recently, tobacco companies have suffered cuts as health-conscious consumers change habits.

“Companies selling direct to consumers will get squeezed,” said Charles Glasse, a portfolio manager at Waverton Investment Management, which ran some of 2016’s best-performing funds, according to Lipper data.

Instead, areas where companies face limited competition, whether by industry or geography, tend to fare better in times of rising inflation.

“These tend to be in sectors that are a little less exciting and not very well-known, such as industrial gases or chemicals,” Glasse said.

As investors gear up for the corporate earnings results due over the next four weeks, they are likely to be particularly cognizant of rising costs and margin pressures as above average valuations leave little scope for disappointment.

“Whilst a pick-up in inflation will flatter some, many companies will have to deal with more expensive inputs - an issue they have not seen for some time,” said Derek Stuart, manager of the Artemis UK Special Situations Fund in his outlook for 2017. (Graphics by Vikram Subhedar, editing by Larry King)

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