2 share ideas to survive stagflation

Back in 1965, MP Iain Macleod addressed the House of Commons and said: "We now have the worst of both worlds – not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of 'stagflation' situation."

And so, the term stagflation was born.

There’s no hard and fast definition. But for most, it means a period of high inflation coupled with low, or even falling, economic growth. This especially nasty blend of economic conditions is fairly rare. To find the last prolonged period of stagflation, we have to head back to the 70s.

In the UK, inflation has risen throughout 2022. The UK consumer price index, a measure of inflation, rose 9% in April year-on-year – the largest increase in 40 years. At the same time, economic growth, measured by gross domestic product (GDP) has been under pressure. GDP was down 0.3% in April, the second monthly decline in a row.

And so, we have both sides of the stagflation equation – high inflation and declining growth.

What performs well during stagflation?

If we look back in time, defensive companies have tended to perform better in periods of stagflation.

These are businesses whose products and services are essential to everyday life. Irrespective of whether cash is tight, people need to eat and pay water bills, businesses need to pay rent and so on. These would include sectors like utilities, real estate, and consumer staples.

Remember though, past performance isn’t a guide to the future.

Commodities have also tended to do well. Gold was a real winner during the late 70s. Investors have long used gold as a ‘safe haven’ when there are fears about inflation and the wider economy.

With that in mind, here are two companies that could hold up well if stagflation sticks around.

This article isn’t personal advice. If you’re not sure if an investment’s right for you, seek advice. All investments can rise and fall in value, so you could get back less than you invest.

Investing in individual companies isn’t right for everyone – it’s higher risk as your investment is dependent on the fate of that company. If a company fails, you risk losing your whole investment. You should make sure you understand the companies you’re investing in, their specific risks, and make sure any shares you own are held as part of a diversified portfolio.

The shiny stuff

From an investor’s standpoint, there wasn’t too much to cheer about during the 70s. Gold was one of a few exceptions.

At the start of the decade, you could pick up an ounce of gold for around $35. By the 80s, that soared to around $500. Of course, there’s no guarantee that performance can be replicated.

Newmont is the world’s largest producer of gold, with over six million ounces expected in the current financial year. The group’s mines span Africa, Australia, North & South America, including several high-quality mines with long lifespans.

The group also digs up other metals like silver, lead and zinc, but gold is the main performance driver, equating to around 82% of production last year. Recent higher gold prices have done wonders for profits. It costs the group $1,156 per ounce to dig the stuff up, but it’s currently selling it on at $1,892.

Newmont revenue vs gold price

Past performance isn’t a guide to the future. Source: Refinitiv Eikon, 17/06/22. Orange shows estimated figures.

The higher gold price feeds through to bumper revenue and free cash flow, with analysts expecting the latter to come in around $2.2bn by the end of the year. In fact, starting from a base of $1,200 per ounce, every $100 increase in the gold price brings in around $400m in additional free cash flow.

With a dividend framework that aims to pay a base dividend of $1 per share and then 40-60% of any free cash flow generated from gold prices being above $1,200 – that’s led to some hefty dividends. Plus a $1bn share buyback program that’s underway. Of course, no shareholder returns are ever guaranteed.

Total dividends ($m)

Past performance is not a guide to the future. Source: Refinitiv Eikon, 17/06/22. Green bar shows an estimated figure.

Looking to the future, investment’s mainly focused on expanding existing gold mines. That’s to help make sure production remains on a stable footing for the next decade and upgrading to bring down costs. These projects are often locked in for a number of years and spending’s expected to run north of $2bn this year, up 40%.

Upgrades like these don’t come cheap and we think taking advantage of current conditions to fund upgrades is a good move. Though of course, tying up capital could become a burden if conditions materially change.

Further out, the group’s looking to expand its exposure to copper. Not a bad move given copper’s a key material for the global energy transition.

Ultimately the biggest risk to Newmont is largely out of its own control, and that’s the gold price. Somewhat a double-edged sword, given current prices are supporting the 3.3% dividend yield and buyback plan. Remember, yields are variable, not guaranteed nor a reliable indicator of future income.

Nevertheless, gold has the potential to thrive in uncertain times and Newmont is well placed to capitalise if it does. However, if the gold price falls, those returns will likely be reviewed and the higher-than-average valuation could come under pressure.

VIEW THE LATEST NEWMONT SHARE PRICE AND HOW TO DEAL

Go defensive

As broader risk-on assets come under pressure from higher interest rates and a potential recession, defensive stocks tend to step into the light. There’s something to be said for steady, more reliable income streams and United Utilities could offer just that.

The group provides water and wastewater services to Northwest England, maintaining and operating thousands of kilometres of pipes and hundreds of treatment works in the process.

In return for providing an essential service, the regulator allows water companies to earn a reasonable return on the water they sell. Prices are set by the regulator, Ofwat, and are reviewed every five years (the next review due in 2024). It’s not in anyone’s interest to have water companies struggling to make ends meet, so earnings and cash flows tend to be relatively stable.

Operating cash flow (£m)

Source: Refinitiv Eikon, 17/06/22.

And that supports one of the group’s main attractions, a 4.4% prospective dividend yield. This is propped up by a healthy balance sheet and over £300m in free cash flow last year.

Impressively, the dividend’s grown every year since 2008 and the current policy aims to grow the dividend by inflation each year through to 2025. Remember, no dividend is guaranteed, and yields are not a reliable indicator of future income.

Water providers have an ace up their sleeves when it comes to battling inflation.

A key metric used by the regulator in setting prices is the Regulatory Capital Value (RCV), a measure of market value plus planned investment. The RCV gets updated every year and has an element of inflation built in, essentially higher inflation leads to a higher RCV.

When prices are reviewed, the regulator looks to make sure a reasonable return on capital can be achieved. It uses the RCV to do that. The result is prices and therefore revenue streams that can flex with inflation.

Although, having an element of inflation hedging on the revenue side doesn’t mean there aren’t downsides to inflation.

Servicing inflation-linked debt is the biggest concern, with finance expenses expected to rise around £150m this financial year. Operating costs are also expected to jump, to the tune of £100m, with around half of that due to inflated costs. That’s manageable for now, but a lengthy period of increasing costs could see investment, or the dividend, come under pressure.

United Utilities’ defensive nature has been sought after in today’s uncertain market. Water demand is as fundamental as it gets, but you’ll have to pay extra for that strength in the current environment. The group trades on a forward price to earnings ratio of 27.2, ahead of the longer-term average.

VIEW THE LATEST UNITED UTILITIES SHARE PRICE AND HOW TO DEAL

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Inflation, wage-price spirals and recessions – what can we learn from the past?

Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.