Two weeks ago the retail inflation figure was released, which was 6.8% per year, a figure not seen for 40 years. And last week another record was announced: wholesale inflation.
While retail inflation is measured through the CPI (Consumer Price Index), wholesale inflation is recorded with the PPI (Producer Price Index). The PPI measures the change in prices received by domestic producers of goods and services. Unlike the CPI (which has the consumer’s perspective), the PPI measures the producer’s perspective.
Wholesale inflation was the highest since 2010, reaching 9.6% per year. The rising prices of gas, food, iron and steel were the main drivers of the increase.
A very common mistake is to think that wholesale inflation can be completely transferred to prices, transferring the cost to the final consumer. This statement is incorrect.
End consumers cannot pay just any price, so companies cannot pass their cost increases into the price paid by the retailer. What happens then? They are forced to sell at a lower price, squeezing their profit margins. (Technical note: this depends on how inelastic the demand for a good is. Laboratories can pass a large part of the cost into the final price because the demand for drugs is very inelastic).
Situation of US SMEs
This week, the NFIB (National Federation of Independent Business) released the results of a survey of US small and medium-sized businesses.
The thinking of these types of companies is a good indicator of inflationary trends since they are the ones that mostly deal with the crossroads of prices.
In the following graph you will see the median CPI (blue line) together with the price plans that SMEs estimate for 10 months (red line):
It can be clearly seen, that small businesses are projecting higher inflation for next year. This should concern the market as they are a great indicator of real inflation, as seen in the graph.
The Fed, for its part, announced a tighter monetary policy (hawkish), which implies an acceleration in the removal of stimuli to the economy through the reduction in the purchase of bonds. In addition, they expect three increases in the interest rate in 2022 to attack the inflationary problem. Seeing the violence of the inflationary rise, very shortly afterwards, it will be obvious that three increases will not be enough.
The inevitable consequence is that US companies will make less money next year as their profit margins will be squeezed.
Please follow this reasoning carefully:
If we have margin compression and stocks fall 15%, they will continue to be just as ultra expensive as today, if we value them by valuation metrics such as Price-to-Earnings The Price-to-Sales.
If we add margin compression to a return to levels closer to the average in valuation metrics such as Price-to-Sales Y Price-to-Earnings, drops of 50% from current levels would be perfectly possible. Do you still want to do buy and hold?
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