© Reuters. FILE PHOTO: People are seen on Wall Street outside the New York Stock Exchange (NYSE) in New York City, U.S., March 19, 2021. REUTERS/Brendan McDermid

By Lewis Krauskopf

NEW YORK (Reuters) – Worries over inflation are rippling through the U.S. stock market, spooking equities overall while causing investors to consider which shares can hold up better in an environment where inflation may be heating up.

Inflation talk grew on Wednesday as data showed U.S. consumer prices increased by the most in nearly 12 years in April.

Rising prices and costs can crimp consumer demand and corporate profitability. They could also pressure the Fed to tighten monetary policy, which in turn could harm economic growth and stock valuations.

“Some inflation for companies and markets are healthy,” said Keith Lerner, chief market strategist at Truist Advisory Services. “There’s a sweet spot and then it gets to a place where it gets a bit too hot.”

Research by UBS equity strategists found the starts moving in the opposite direction to inflation expectations when the breakeven rate on the 10-year U.S. Treasury Inflation-Protected Securities (TIPS) — a market-based measure of inflation — exceeds 2.5%. The rate rose above that level in the past week for the first time since 2013, according to Refinitiv data.

Here are some stocks groups to watch as inflationary concerns rise:

REFLATION VS INFLATION: Investors anticipating an economic rebound from the coronavirus pandemic have moved into cyclical sectors expected to see profits pick up in a “reflationary” environment.

Financials stocks surged this year as longer-dated Treasury yields climbed. But if the Fed raises short-term rates to combat inflation, that could flatten the yield curve, so “the spread between borrowing and lending narrows for the banking sector and results in a net interest margins squeeze,” according to BCA Research.

“Depending on how far up the inflation expectations you want to move, financials benefit and then at some point they don’t,” said Jack Janasiewicz, portfolio manager at Natixis Investment Managers.

Industrials, another cyclical group that has outperformed, are “located in the middle of the economic value chain and thus (have) diminishing power to pass on inflationary cost increases,” according to BCA.

“Keep the S&P industrials index in the overweight basket early on into an inflationary spike,” the firm says in a note, “but do not overstay your welcome as inflation endures.”

COMMODITY-LINKED STOCKS: Two other cyclical groups, materials and energy, may be better positioned to weather inflation. They are more tightly linked to prices of commodities and raw materials, many of which have hit new heights recently.

So far this month, ETFs for gold miners, miners and steel, have climbed between 7% and 9%, with the S&P 500 materials sector up about 3%, while the S&P 500 has posted a nearly 3% decline.

How much more room commodity prices have to run remains to be seen, however, and equities linked to those commodities may fall back if prices abate.

PRICING POWER: A rising inflation environment will increase costs for companies, so investors will be looking for companies that can pass along those costs through increased prices.

Companies with strong relative pricing power, according to UBS, include Activision Blizzard (NASDAQ:), Coca-Cola (NYSE:), and Abercrombie & Fitch.

Broadly, consumer staples companies are seen by some strategists as relatively well equipped to pass through price increases.

“The investing premise is that the necessity aspect of Consumer Staples means their demand is inelastic, allowing for price increases during an inflationary cycle,” Michael O’Rourke, chief market strategist at JonesTrading, said in a recent note.

Whether that premise bears out will be closely watched. For example, Procter & Gamble (NYSE:) Co said last month it would raise prices of certain products in the United States to offset rising costs.

TECH TRIPPED UP: Tech stocks have struggled this week, and some investors are pointing to inflationary concerns contributing to the weakness.

Following the consumer price data, the yield on the benchmark 10-year Treasury note rose to its highest level in about a month. Such higher yields pressure valuations for tech and other growth stocks, whose future cash flows are discounted at higher rates.

“It’s not inflation, per se; it’s inflation and the implications for interest rates,” said Jack Ablin, chief investment officer at Cresset Capital Management. “It just leaves tech investors somewhat vulnerable because that tailwind of lower rates and valuation expansion is no longer on their side.”





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