Inflation as an emerging risk: developing a new model for risk management
Traditional risk models, while indispensable tools for asset managers, are typically ill-suited to measure the impact or significance of sudden market dislocations and emerging trends. Focusing on inflation as an emerging risk, we’ve created a proprietary model for identifying companies that may be resilient to current inflationary dynamics.
Institutional investors have a wide range of tools to identify risks in their portfolios. These quantitative measures are typically based on historical observations; however, market dislocations and the unfolding of new events can lead to the emergence of new risks, which by their nature as “new phenomena” are unlikely to be swiftly and accurately identified. Even once conceptually understood, it often takes time for new risks to be incorporated into general risk models. As such, assessing emerging risks requires an expanded risk management tool kit. Firms able to create proprietary risk tools and models may be better placed to more thoroughly assess these risks as they arise. Following is a case study evaluating inflation as an emerging risk and applying a methodology to identifying companies that may show relative strength in a higher inflationary environment.
Case study: higher inflation as an emerging risk
In February 2022, the Consumer Price Index (CPI) reached a high of 7.90% year over year, which is more than three times the average of CPI (2.20%) over the past 20 years. As we haven’t seen developed market inflation at these levels for a considerable time, forecasting its effect is somewhat difficult, and relying on historical observations and correlation might not be prudent. However, we can create metrics that allow us to forecast which companies may be most vulnerable to this phenomenon and conversely those that may be better placed to withstand higher inflation.
Assessing pricing power
Inflation affects companies’ profitability in numerous ways: It may erode individuals’ purchasing power and therefore alter consumer demand. It may also directly affect production costs. Companies that are unable to transfer inflation to end consumers may experience a negative effect on their profitability.
Pricing power enables companies to pass a portion of inflation to customers without significantly disrupting demand. Pricing power is typically achieved if a company:
- Has a product with limited substitutes (i.e., it’s essential for customers)
- Operates in a market with high barriers to entry for competitors
- Enjoys growing demand with low price elasticity
Current pricing power may be an indication of future pricing power. Companies with higher pricing power often benefit from higher margins and higher margin quality. The higher the margin quality, the less significantly margins may fluctuate; in addition, high margin quality may indicate that a company can successfully increase its margin without disrupting demand for its goods and services.
To evaluate the potential impact of inflation on investment portfolios, we constructed a model aimed at measuring pricing power for different companies and sectors. Higher pricing power is used as an indicator of relative resilience to higher inflation.
In this model, we use the following metrics:
- Gross margin—This is calculated earlier in the income statement and, therefore, is less susceptible to accounting practices. Average gross margin over the past five years is used.
- Margin stability—or stability of gross margins—helps us identify well-positioned companies that can protect margins from experiencing large movements. The model uses the standard deviation of gross margins over the past five years to measure margin stability.
- Margin growth—Margin growth can indicate the willingness of end customers to accept higher prices. In addition, the inclusion of this factor reduces the impact of positive margin volatility in the model. In other words, companies with higher margin volatility due to increasing margins should be comparatively less vulnerable to higher inflation. Margin growth is also calculated based on gross margin levels over the past five years.
As the model evaluates the pricing power of firms, the results can be rolled up for any portfolio or index of listed equities.
Applying pricing power to the MSCI World Index
The MSCI World Index tracks the performance of publicly traded large- and mid-cap stocks of developed market companies. This makes it a useful proxy to measure sector strength across the world’s most dominant companies, particularly those based in North America and Europe.
Analyzing pricing factors—gross margins, margin stability, and margin growth—provides measures of sector strength against each variable.
Assessing sector strength
Manulife Investment Management pricing power model
We can draw several conclusions from the analysis of these factors applied to the MSCI World Index:
- Margin growth versus margin shows strength in the healthcare, information technology, and communication services sectors, and the ability of these sectors to produce higher-than-average margins. Information technology enjoys higher-than-average margin and experiences higher margin growth levels. This is in contrast to the communication services sector in which margins are strong but aren't increasing.
- Margin growth versus margin stability shows that the information technology and consumer staples sectors currently deliver high and stable gross margins.
- Margin stability versus margin shows healthcare, information technology, and communication services delivering higher average margins. Among these, communication services has the lowest margin stability.
The foregoing analysis provides valuable insight into sector strength in terms of specific pricing power measures. Then, when we aggregate results for each factor, we’re able to discern relative sector strength. This enables us to highlight sectors with the strongest pricing power and, therefore, those with better potential to withstand a higher-inflationary environment.
Sector pricing power score
MSCI World Index, Manulife Investment Management pricing power model, January 2022.
On a relative basis, healthcare, information technology, consumer staples, and communication services show the highest levels of pricing power. As companies and the overall market change, pricing power may change. Therefore, by producing a single illustration of scores for each sector, the model can be deployed to measure the relative pricing power of companies and sectors at any point in a market cycle.
Deploying risk models effectively
Quantitative models and analysis are useful tools in risk measurement, but each measure also carries an inherent limitation in what it can achieve. Risk management requires active engagement and understanding by an experienced risk analyst to properly calibrate and interpret risk statistics, which can be misleading in isolation.
In this article, we have gone beyond calibrating models to demonstrate how novel market phenomena can be explored by creating a transparent repeatable model to assess the most likely exposed areas of a portfolio. In our experience, this quantitative analysis can then be usefully deployed in conjunction with fundamental specialists to pinpoint areas of potential investment risk and opportunity.
The model evaluates each company based on the aforementioned measures, and each measure for a company is standardized based on all names in the total universe—including our equity portfolios and their respective benchmarks. Market weights are used to calculate the score of each sector based on the index constituents. Sector rankings are driven by constituents of each sector in a benchmark and sectors will not rank similarly in different indexes as names and weightings are different. Margins may be affected by factors other than pricing power. Certain sectors—namely energy, material, utilities, and financials—were excluded from the model for this reason.
A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange-trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future, could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other pre-existing political, social and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment.
Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. These risks are magnified for investments made in emerging markets. Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a portfolio’s investments.
The information provided does not take into account the suitability, investment objectives, financial situation, or particular needs of any specific person. You should consider the suitability of any type of investment for your circumstances and, if necessary, seek professional advice.
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