INVESTORS PUZZLED BY INFLATION DATA
Companies send unclear messages about rising cost of goods and labour
UNITED States quarterly earnings reports this month were supposed to give investors clarity about the health of Wall Street’s rally this year.
Instead, profit reports and forecasts following the most recent three months are giving investors indigestion as companies send unclear messages about the rising cost of goods and labour.
“I don’t understand why people are so hesitant to admit that we’re in an upturn in inflation,” said Richard Bernstein, chief executive of Richard Bernstein Advisors LLC.
Companies, he said, are “scared that they’re not going to get rewarded for pricing growth”.
The unexplained absence of inflation during the last decade’s US equity price boom is now being replaced in investor psychology by fears that inflation is finally pushing up costs and squeezing margins and may be one of the culprits in this month’s selloff of US stocks.
US consumer price inflation was 2.3 per cent in the year to September, according to the Labour Department, and even “core” inflation, which strips out volatile food and energy prices, is running at 2.2 per cent for the year, above the Federal Reserve’s (Fed) target.
With unemployment at 3.7 per cent, the lowest in nearly 40 years, annual wage growth was 2.9 per cent in September, a nineyear high.
The question is whether the cost increases companies say they are now absorbing are fleeting or here to stay.
At stake is a market rally built on the premise that stock valuations are justified by earnings that go on growing.
While earnings growth is still high at 22 per cent so far this quarter, the amount by which S&P 500 index companies are beating analyst estimates is nearly half of what it was during the first quarter, according to Refinitiv data.
Unless companies can raise prices fast enough to keep up with the rising costs of hiring and materials, stocks may struggle to maintain current valuations.
Borrowing costs are also rising as the Fed is expected to keep raising interest rates into 2019 to wards off the inflationary threat, with US economy growing at 4.2 per cent in the second quarter this year, helped by last year’s US$1.5 trillion worth of tax cuts.
And now US businesses are also warning of input costs rising as a result of President Donald Trump’s imposition of import tariffs. Steel and aluminium tariffs have cost Ford Motor Co about US$1 billion in profits, its chief executive officer said last month.
“Market participants are really concerned that maybe finally we have seen peak earnings and that people are talking much more about costs rising and, looking ahead, corporate profit margins could certainly come under pressure,” said Fritz Folts, chief investment strategist at 3EDGE Asset Management LP.
Corporate leaders sit on the frontline of inflation, but they are not offering consistent guidance about where they expect the trend to go from here. The divergence in guidance and outlooks is costing investors money.
On October 8, paint-maker PPG Industries Inc told investors to expect lower profits, saying that it expected the prices for the raw materials it uses to keep rising, and its stock fell 10 per cent during the following trading session. Economist Ed Yardeni said the forecast help set the stage for the broader market selloff later that week.
Yet PPG’s rival, Akzo Nobel NV, said nine days later that it thinks inflation on those sorts of items has peaked for the year. Akzo shares rallied 3.0 per cent.
“There’s anecdotes about inflation pressures, but when you add them up we're not seeing it in the macro indicators,” said Yardeni.
The Fed’s own “Beige Book” collection of anecdotal evidence on business conditions, published on Wednesday, said inflation has appeared modest or moderate in most parts of the country.
Investors are rewarding companies that can keep up with inflation and punishing those that cannot.
So far this year, companies with high operating leverage, typically meaning they can generate additional profits with relatively small increases in their costs, have returned 13 per cent, including dividends, according to Goldman Sachs Group Inc data.
By comparison the S&P 500 has returned about 0.9 per cent.
And anecdotes about costs abound.
At Del Taco Restaurants Inc, executives warned on an earnings call earlier this month that food inflation will increase next year and its labour costs will grow too, given an increase in California’s minimum wage, despite efforts to minimise labour by using food processing machines to cut more cheese and tomatoes. The company hopes to offset those at least some of those increases by raising prices.
Del Taco shares fell to a more than two-year low.
But inflation has helped other companies.
Nestle and Unilever , two of the world’s biggest consumer goods makers, both reported a pick-up in sales recently as inflation helped give them greater scope to push through price hikes. Both companies' shares rose on the news.
While inflation has risen and is a concern, markets generally see it contained.