Amid rising inflation data, fixed income investors have been searching to understand how high inflation will go, what the real drivers are, and importantly, how long it will last. While the trajectory of inflation will impact a range of assets, its impact on corporate credit quality should not be overlooked.
Over the next 12 months, we expect investment grade credit fundamentals to improve despite inflationary pressures. Accelerating economic growth following post-pandemic lifting of government restrictions, vaccine rollouts and fiscal stimulus will likely translate into strong EBITDA growth and natural deleveraging.
While we are optimistic about investment grade credit fundamentals overall, not all sectors are created equal. Commodity-producing sectors like energy, mining and chemicals typically benefit the most during periods of inflation due to rising commodity prices. We expect this group to have expanding margins and improving cash flow.
At the other end of the spectrum, sectors experiencing cost inflation with less pricing power should see margin pressure. We believe the food/beverage, retail and consumer products sectors fall into this category, and we expect them to face margin headwinds over the coming quarters, until inflation eases or price increases can be more fully implemented.
Larger companies may find it easier to navigate this environment of rising cost pressures. Based on comments on its quarterly earning calls, for example, Wal-Mart is leveraging its bargaining power with suppliers to maintain low prices and grow market share. Similarly, Cisco is using its strong positioning in the technology sector to absorb cost increases it views as transitory to grow market share.
Based on our analysis and conversations with management teams, we expect the majority of commodity-based inflation to prove transitory. As we have seen in the past, commodity cycles come and go, and while we expect unevenness and lingering issues, supply chain disruptions will likely improve as the year progresses. Wage inflation has been less prevalent so far, but we think this is a larger risk as it could prove to be stickier. Despite the low-visibility inflationary environment, we remain bullish on investment grade credit fundamentals, but are monitoring wages and whether any of the issues that appear transitory become more sustained.