Throughout the bear market of 2022, Diageo shares remained notably resilient. The drinks giant was buoyed by the strength of its iconic brands like Johnnie Walker, Guinness, Baileys, Smirnoff, and Captain Morgan, along with the seemingly inelastic, or steady, demand for alcohol. After all, economic downturns might conceivably encourage people to drink more, despite having less money.
However, the economic clouds have since begun to disperse. The term “soft landing” has become a common refrain. At the same time, Diageo’s shares have been bombing. Compared with its peak of April 2022, the share price is down 28%.
But I am bullish on Diageo shares, because I think the market is underestimating the risk of a return to the bad old days of 2022. I see reasons to think the US economy, which is so critical to global trade and equity markets, will fall into recession. At the same time, I see one important factor threatening to drive a resurgence in inflation.
Recession signals and inflation concerns
The yield curve inversion, a reliable harbinger of US recessions, has been scaring investors since the summer of 2022. Despite this, the US economy has shown remarkable resilience, with robust growth and job creation.
But that does not mean the US economy is out of the woods yet. After all, yield-curve inversion is a leading indicator. In other words, it flashes on the control board long before trouble hits.
At the same time, reports from the Panama Canal and the Suez Canal tell of trade disruptions which could cause inflation to take off again.
The Panama Canal has narrowed due to drought, leading to congestion and diverted ships. Meanwhile, the Suez Canal has seen traffic fall by 50% due to attacks by the Houthis on merchant ships. All of this spells higher freight costs as insurance premiums spike and waiting times for parts and products soar.
My theory is that a stagflationary environment would send investors scrabbling for defensive, value stocks once again, as occurred during 2022. To clarify, stagflation is when inflation is high at the same time that economic growth takes a nosedive.
Taking a look at the figures
Diageo’s recent financial performance paints a picture of resilience and potential. With a price-to-earnings (P/E) ratio of 18, Diageo appears reasonably valued, especially when compared to peers like Coca-Cola and PepsiCo, which trade at higher multiples (24 and 29, respectively).
Moreover, Diageo’s latest interim results reveal a company that, despite facing challenges, particularly in the Latin America and Caribbean region, has managed to grow its net sales and operating profit organically in other key markets.
Time to buy?
I see companies like Diageo, which sell products with inelastic demand and brand loyalty, getting a boost in the event of stagflation.
Of course, if consumers really got squeezed, they might have no choice but to switch to knock-off brands to save money. At the same time, teetotalism is rising among the younger generations, which thins out Diageo’s potential market.
Nevertheless, the company’s robust brand portfolio and proven ability to generate cash provide a buffer against recessions. I plan on adding Diageo stock to my portfolio when I next have spare money.
