Sunday, October 24

Three Stock Market Rebuttals to the Inflation Cassandra Case


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(Bloomberg) — Fears about margin-shredding inflation are palpable among corporate executives and Wall Street analysts, but equity investors are relatively sanguine.

Shares of companies with higher pricing power — the capacity to pass on costs to customers without harming the business — are crumbling relatives to their less-advantaged peers. Meanwhile, S&P 500 stocks with the highest labor costs are trouncing firms with relatively low ones. And corporate operating margins are at all-time highs.

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That stands in stark contrast to the alarm bells ringing all over Corporate America. Nike Inc. and FedEx Corp. are among the companies forced to slash forecasts in recent weeks, thanks to a toxic combination of shipping delays, higher input costs and rising wages. Morgan Stanley warned on Friday that the worst isn’t over, particularly for retailers, as supply chain and freight inflation heats up just as sales are decelerating.

While equity market leadership reveals that inflation is having an impact — energy shares were the only sector to post a gain last month — fear is largely absent as investors choose to train attention on growth, according to Richard Bernstein Advisors LLC’s Dan Suzuki.

“The market has been much more focused on interest rates and growth, rather than inflation specifically. The fact that energy stocks were up double digits, while everything else was down, tells you that inflation is having an impact,” said Suzuki, the firm’s deputy chief investment officer. “It’s just not necessarily something that is generating a lot of fear for markets at present.”

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Pricing Power

That focus on spiking interest rates may explain why shares of technology companies, which theoretically have ample ability to offload costs to consumers, have underperformed in recent weeks. Rates on 10-year Treasuries careened to the highest level since June this week, rattling risk assets and expensively priced tech stocks. The Nasdaq 100 tumbled for a fourth straight week, outpacing a decline in the broader S&P 500.

Equity baskets tracked by Goldman Sachs Group Inc. show that the dynamic spreads beyond tech. Companies with higher pricing power — a cohort that includes Colgate-Palmolive, Procter & Gamble and Dollar General — underperformed low pricing power firms such as Boeing and Disney by the most since November 2020 last month.

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“I don’t think the market is fully factoring in increased costs that can’t be passed on,” said Chris Zaccarelli, chief investment officer at Independent Advisor Alliance. “Virtually every company has mentioned increased costs on their previous conference calls. The belief that costs can be passed on across the board — which I don’t personally believe — is one explanation for why low pricing power companies could outperform, when theoretically they shouldn’t be.”

Labor Costs

How equity markets are handling increased labor costs is also unintuitive. A Goldman Sachs basket of S&P 500 stocks with the highest labor costs as a percentage of revenue trounced low-cost counterparts by 8.5 percentage points last quarter, the best showing since the data began in 2010. The baskets strip out industry biases.

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“There’s some recognition that there will be near-term risks to earnings from both input and labor-cost pressures, but also supply shortages,” RBA’s Suzuki said. But even still, “some of the most labor-intensive sectors have outperformed in September , from financials to consumer and health-care companies.”

The dynamic boils down to the fact that investors are once again loading up on cyclical names, despite the heavy overhangs of worker shortages and rising labor costs, Suzuki said.

Record Margins

And even with all the hand-wringing over what damage rising input costs will do to bottom lines, margins have held up and then some. Operating margins for the S&P 500 clocked in at 14.4% last quarter, a record high, with companies in many cases actually benefitting from the inflation that executives are fretting about.

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S&P 500 profits as a percentage of revenue have soared over 91% from their pandemic lows to 17.4%, above the prior cycle’s peak of 16.4%, according to data from Credit Suisse compiled by Jonathan Golub. All sectors have seen margins grow, though financials and cyclicals outpaced tech companies.

While that measure of margins is still below the all-time high of 18.8% in 2007, Golub sees further upside. However, megacap tech has less room to rebound, with margins already at records.

“TECH+ EBIT margins fell more modestly during the pandemic (23.6% to 18.9%), and currently sit at all-time highs (24.5%),” Golub, the firm’s chief US equity strategist and head of quantitative research, wrote in a note Thursday. “We believe margin upside will be more limited for TECH+ companies given their lack of operating leverage.”

©2021 Bloomberg LP

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