Three ASX inflation-benefitting stocks to watch in October 2022

From February 2020 to February 2022, the Reserve Bank of Australia (RBA) expanded the money supply by an unprecedented 375%. Of the $549.5 billion in currency and call accounts, over $400 billion didn’t exist three years ago.

Increases in the money supply of this magnitude tend to create inflation, and we’re seeing some right now.

In June 2022, the Consumer Price Index (CPI) hit a 30-year high of 6.1%. The last time CPI exceeded this level was December 1990, after Saddam Hussain invaded Kuwait.

The RBA forecast back in May that the CPI would remain above 4% at least until the end of 2023.

Some components of inflation are rising even faster:

• Weekly rents in Sydney rose by 23.7% in September 2022 compared to a year ago, according to SQM Research
• Weekly rents nationally rose by 14.8% over the same period
• The average spot price of electricity (excluding WA and NT) for August 2022 increased by 221% compared to August 2021

So, who will benefit from increased inflation over the next 12-24 months?

Here are the three stocks to watch:

1. Origin Energy – energy production
2. Commonwealth Bank – banking
3. Insurance Australia – floating rate note

Origin Energy Limited

Origin Energy Ltd is involved in the exploration and production of natural gas in Australia, electricity generation, wholesale and retail sale of natural gas and electricity, and the sale of liquefied natural gas in Australia and for export.

Origin’s share price suffered during the pandemic, as did its bottom line. The company recorded impairment losses in 2020-22 totalling $4.9 billion and net losses of over $2.3 billion and $1.4 billion in 2021 and 2022, respectively. Of the $2.6 billion in impairment losses in 2022, $2.2 billion were hedging losses due to higher electricity and natural gas prices.

In 2020 and 2022, Origin also recorded operating losses of $0.2 billion and $0.7 billion, respectively.

However, things are looking up for Origin.

Wholesale electricity prices have risen significantly over the past year. For the 2022 financial year ending in June, Origin made a $713 million profit despite hedging losses, compared to a $348 million loss in the prior year.

Origin made a $92 million profit in its oil and gas division due to rising gas prices for the 2022 financial year ending in June, compared to a $231 million loss the previous year.

As long as inflation continues to affect natural gas and electricity prices, Origin appears to be well positioned to benefit.

Commonwealth Bank Limited

In terms of banks benefiting from inflation, there isn’t a lot to differentiate between the big four banks: Commonwealth Bank of Australia, Westpac Banking Corp, Australia & New Zealand Banking Group Ltd, and National Australia Bank Ltd.

The reason for singling out Commonwealth Bank is its portfolio weighting towards mortgages – it has the highest exposure.

Mortgages as a percent of total exposure at default:

Source: Fitch Ratings

Banks benefit from rising inflation in two ways:

1. Higher asset prices reduce loan losses from mortgages
2. As the central bank reacts and raises interest rates, bank interest margins rise

Higher asset prices reduce loan losses

A simple calculation for a profit from a mortgage is:

Profit = interest margin + fees - costs - loss at default

Interest margins are fairly constant as most bank loans are adjustable within five years. Fees and costs, too, are fairly standard as mortgages are standardised products.

In the event of a default, the bank can lose money when the costs associated with taking possession of the mortgaged asset and selling it exceed the initial deposit and capital payments received. These losses expand rapidly if housing prices fall – as happened in the US in 2008. However, if housing prices rise, then the chance of recording a loss in the event of default falls.

Commonwealth Bank appears to be best positioned to benefit from lower loan losses. Over the past two years, the bank’s provisioning losses turned around from $2.5 billion loss in 2020 to a profit (reversal in provisionings) of $357 million in 2022. Further housing price inflation could contribute to lower provisioning losses in the coming 1-2 years.

Interest margins may rise

Banks benefit from rising interest rates when lending rates outpace deposit rates. While term deposit interest rates appear to be rising in tandem with RBA rate rises, as are variable rate mortgages, interest rates on call accounts and chequing accounts remain close to zero.

As of 30 June 2022, Commonwealth Bank had only $158 million in term deposits and Certificates of Deposit (CDs) out of $745 million in total Australian deposits. The rest were in lower interest short-term deposits and zero interest deposits.

Meanwhile, home loans totalled $556 million.

Commonwealth Bank appears to be well positioned to benefit from rising interest rates if loan rates rise faster than deposit rates and increase net interest margin.

Insurance Australia Floating Rate Note

The Insurance Australia Floating Rate Note (ASX:IAGPD] is more of a fixed-income investment than equity. IAG issued $300m in these shares in 2016 and they convert into ordinary shares on 16 June 2025. These are subordinated unsecured notes, which means they are higher risk than other IAG debt, but lower risk than equity. IAG issued this floating rate note to improve its Tier 1 Capital adequacy ratio.

IAGPD is not a direct beneficiary of inflation. However, it will benefit from the consequent rising interest rates because it has floating rate payments – similar to a floating rate mortgage. The interest (dividends) paid on these notes is paid quarterly at an annualised rate of 4.7% above the 90-day bank bill swap rate. So as interest rates rise, so too will the dividend yield.

The September 2022 dividend was $1.242 (annualised at $4.968, or 4.968% for the $100 par value), reflecting the previous 90-day bank bill swap rate of 0.268. Now that interest rates are rising, and the 90-day swap rate has risen to 2.9% as of 26 September, these yields should climb towards 7.6%, based on the $100 par value. IAGPD generally trades slightly above par, with a 52-week range of 100.01 to 105.50.

This appears to make IAGPD a beneficiary of the rising interest rates the RBA is using to fight inflation.

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