Hunting for quality retail shares on the move as inflation stalks the market

It has been a long time since stock market investors have had to concern themselves with the rate of inflation in the economy. But we’ve started to hear a lot more about it in recent months. So what does the prospect of resurgent inflation really mean, and how might the latest figures influence the search for stock picking ideas?

A general rule is that over the long term, assuming corporate earnings rise as expected, investing in shares is a hedge against inflation. Good companies - especially those with pricing power - should be able to pass on rising input prices to their customers without much of a problem.

But in the short term, a rising rate of erosion in the purchasing power of money can be unsettling. The Bank of England’s main monetary lever to keep it in check is to raise interest rates. But doing that slows the economy down and can lead to consumers and companies putting off buying decisions, which which is negative for stocks. Plus of course, rising rates can make bonds more appealing, which can also act like a drag on share prices.

The rolling 12 month rate of inflation rose from 1.6% to 2.1% between April and May this year. And in June, that rose again to 2.5%. Given that the Bank’s target is 2.0%, you can see why this trend is starting to turn heads.

The question now is whether this inflation is just transient or the start of something a bit more serious. In practice, we won’t really know the answer until well into 2022. But what we do know is what’s driving the current trend. According to the UK’s Office for National Statistics, prices for food, second-hand cars, clothing and footwear, eating and drinking out, and motor fuel have all risen in 2021 (after falling in 2020). Much the same is being seen in the United States and elsewhere.

In part, the reopening of the economy after lockdown has created a very understandable wave of spending. That combined with unusual one-offs (like a passing supply shortage of new cars), is likely to be causing a rise in prices as businesses take advantage of strong demand.

What this means for investors

There are various, often conflicting, views on how investors can navigate inflation. One is that natural resources - both commodities and commodity stocks - can offer protection. Another is to think twice about income stock strategies, because dividend shares tend not to be so appealing in inflationary environments. And another is to avoid expensive, unprofitable growth shares, which can also be losers in these phases.

But more immediately, momentum - and more specifically quality and momentum - could be a useful guide to those shares that are benefiting from the current spending surge - especially in areas like retail.

This screen takes the main retail industry groups and sorts the list based on our dual-factor Quality & Momentum Rank. This looks for stocks with the highest overall exposure to strong financial and business quality and promising trends in both earnings and share prices. The screen isn’t hugely scientific, but it’s an interesting take on where market attention is focused at the moment.

All these shares have seen positive relative share price strength this year - and in different ways they’re all candidates that would benefit from much more upbeat consumer spending - whether it’s on watches and fashion or home improvements and cars.

All eyes on inflation

The easing of Covid restrictions in recent months appears to have unleashed a wave of spending that is washing through several sectors of the economy. Consumer oriented stocks, particularly in retail, appear to be among the first to benefit from this rising demand. After 18 months of turmoil, many companies in these sectors have had a very tough time. So from an investment perspective, it may well pay to focus on business quality and positive momentum to find those shares that are genuinely on the up as the UK gets back on its feet.