Guest Post by Ned Davis Research
Last week’s Consumer Price Index report surprised economists. The CPI jumped 6.2% versus a year earlier, its fastest pace since November 1990. The core CPI rose 4.6.%, its highest since August 1991. Both were well above consensus estimates.
By itself, inflation – even a short-lived spike – is a headwind for stocks. Whether CPI most above 5-yr average since 1980 the headwind is enough to slow one of the strongest bull markets on record depends
on if inflation filters into three areas: company fundamentals, interest rates, and sentiment. All three are not flashing warning signals yet, but whether they do may be one of the biggest determinants of how 2022 unfolds.
One of the challenges when creating an indicator based on a data series like the CPI is that it has trended in one direction for decades. Specifically, the inflation rate had been declining for over 40 years before the recent spike.
A solution is to detrend the data. The middle section of chart above shows the year/year
change in the CPI and its five-year average. The bottom section shows the difference
between the two. The CPI is up 6.2% compared to last year, the five-year average is 2.3%, so the spread is 3.9% points.
Even though “transitory” did not become ubiquitous until a few months ago, every spike in inflation since the March 1980 peak has been proven to be transitory. Stocks have noticed: The S&P 500 Index has fallen at a 1.6% annual rate when the CPI has been more than 1% points above its five-year average since 1980.
The most direct concern we have heard about inflation and stocks pertains to the impact on earnings and profit margins.
The earnings concern is a bit of a myth. Higher inflation has actually been bullish for earnings growth. Two of 12 indicators in NDR’s S&P 500 Earnings Model reflect this tendency. Earnings have risen faster when raw industrial prices have been rising
quickly and the ISM Price Index has been high.
We called the earnings concern a “bit” of a myth because the inflation indicators are likely picking up a stronger economic message as much as higher inflation. The question is whether companies can pass those costs to customers.
The largest input cost for most companies is labor. The chart at left analyzes whether companies can pass costs along by comparing the CPI to unit labor costs. Over the last year, inflation has been outpacing labor costs, which has been bullish for earnings. The spread fell from 5.3% in Q2 to 0.6% in Q3. If the trend continues, it will signal companies are no longer able to pass along higher input costs to consumers.
The pain would be felt not with sales, but with profit margins. For the past 35 years, declines in profit margins have been driven by sales (chart below). Margins have risen until the economy has fallen into recession, and sales have fallen more than costs, resulting in lower margins and earnings. Wage-push inflation would test corporate America’s stellar record on cost controlling over the past three decades.
A more pressing issue in 2022 may be that margins could become a victim of their own success. Profit margins have surged to record highs and done so more quickly than after any recession since the 1970s. Even if companies do manage higher input costs reasonably well, further margin expansion may prove difficult next year.
Higher inflation would push bond yields up, increasing competition for stocks and removing one of the most bullish fundamental rationales for owning equities.
It is no secret that stocks are expensive. At 26.2, the S&P 500 P/E ratio is in the most expensive quintile (20%) in history. Relative to the 10-year Treasury yield, however, stocks are in the cheapest quintile in history.
Because bond yields are so low, the speed of any increase in rates matters. Spikes in the 10-year Treasury yield have been bearish for stocks, even in the ultra-low interest rate environment since the financial crisis. The rally in the 10-year yield since August has not been enough to push the indicator out of its bullish zone.
Higher inflation could also force the Fed to tighten faster than it would have otherwise. In August, we showed that the stock market digested the 2013-2014 QE3 taper reasonably well. One reason why is that the Fed guided the financial markets to a slow pace of rate hikes post taper. The
first hike in December 2015 was months after the taper ended, and it moved at a slow pace thereafter.
Historically, stocks have digested the first year of slow rate tightening cycles (waiting
at least one meeting in between hikes, on average) well, with the S&P 500 rising an average of 10.5%. During the first year of fast tightening cycles (hikes at most meetings), however, the S&P 500 fell 2.7%, on average. A quick transition from taper to frequent tightening would be one of the most bearish consequences of sticky inflation.
Higher inflation would encourage risk-off behavior, with investors likely reducing equity exposure. Inflation concerns would likely be reflected in consumer sentiment surveys. Like other sentiment gauges, consumer sentiment is a contrary indicator for stocks, with optimism tending to be bearish, and pessimism bullish.
The Conference Board’s Consumer Confidence Index has fallen from its June 2021 peak but is still in its extreme optimism zone for stocks. The Reuters/University of Michigan Consumer Expectations Index, however, has fallen 20.3% points in the last six months, enough to put it firmly
in the extreme pessimism zone. Inflation concerns may already be reflected in consumer sentiment. The question is whether they impact profits and interest rates.
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