Inflation Into Earnings
By TRG Advisors on October 14, 2022
Core Inflation Returns to 40-Year High at +8.2% y/y
September’s CPI print recorded a +0.4% m/m step-up in inflation, and an even greater +0.6% m/m increase after excluding food and energy. Core CPI, which excludes food and energy, is up +6.6% y/y,
its highest pace since 1982. Rising prices are broad-based, including household furnishings and supplies +9.9% y/y, new vehicles +9.4% y/y, rent of primary residence +7.2% y/y and medical care +6.5% y/y.
And importantly, while energy prices have subsided in recent months, energy costs remain +19.9% y/y and food prices remain +11.2% y/y. It’s worth pointing out that owner’s equivalent rent accounts for 32% of CPI and contributes quite sticky inflation.
Chart 1: Higher Prices Remain Sticky, Includes Commodity and Services Inflation1
This rise in prices reflects the sustained cost-pressures that consumers are paying, despite the Fed’s historic tightening policy that takes, on average, 6-9 months to impact prices and demand. The Fed is implementing restrictive monetary policy in order to slow demand, which, in-turn, is supposed to lower prices. The Fed has raised their fed funds target rate 300-325 bps, and, after this latest CPI print, another 150 bps is expected across their final two FOMC meetings this year.
The high-inflation scenario that we’re in today was created, in large part, by the Fed’s continued stimulus and aggressive bond purchasing policy that ended earlier this year. The Fed blamed inflation on the transitory rebound in demand after the pandemic, and their easy monetary policy continues to impact today’s economic activity.
The Russia/Ukraine war and continued lockdowns in China have certainly added complexity to today’s environment, but we believe the Fed’s resolve in attacking inflation is serious. The Fed believes strongly that persistent inflation is a greater risk for the economy and households than a recession or pain in the labor markets. And economic data has continued to indicate that, while the economy is slowing, the U.S. economy is still expanding, labor markets remain very tight, and inflation is hot. All contributing to a steadfast Fed mandate toward fighting inflation.
Managing Expectations
While we’ve spent most of the past two months following economic data, sentiment indicators and hearing from central bankers, we are about to finally get an opportunity to hear from the companies
themselves with earnings season upon us. Key watch points: FX rates, interest rates, supply chains and inflation. Pricing power stories will also be important to monitor. We expect outlooks to remain
conservative.
This week, most financial companies are reporting. We’re paying attention to the health of the consumer and small businesses as leading indicators. We’ll find signals within checking and savings
rates, and loan delinquency rates. Financials have benefitted from rising rates in their net interest income and net interest margins, plus some benefits within their trading operations, but asset levels will likely show to have suffered.
Looking to other sectors, energy tailwinds remain significant, boosted by a decade of underinvestment, maximized capacity within existing infrastructure and steady demand. We also expect secular trends to exist in U.S. onshoring as companies bring their supply chains closer to the U.S. consumer-base. Many consumers cyclical companies have been beaten down by negative sentiment, and the leaders we expect not only to survive, but to thrive – capturing greater market share as they continue to invest in innovative products and transform their portfolios. Defensive industries, like health care and utilities, maintain significant pricing power and offer defensive diversification for portfolios.
It’s worth pointing out that, excluding energy, overall earnings are forecasted to be down -2.4%. Including energy, expectations are for +2.6% y/y growth. Excluding Tech+, overall earnings are forecasted to be up +8% y/y.2 We remain bullish toward the energy sector and positioned away from high-multiple technology.
Here’s Some of What We’ve Heard So Far…
Delta Airlines (DAL) reported a rebound in both leisure and business travel during the summer, and indicated better-than-expected earnings and revenues continuing in Q4. This follows American Airlines (AAL) pre-announcing a higher revenue outlook earlier this week, and United Airlines (UAL) raising their outlook in September. The theme here is that higher prices are sticking, and staffing problems have recovered – creating better reliability and efficiency. Both leisure and business demand contributed to the strong Q3 for airlines, and pricing power is expected to continue in Q4.
Semiconductor companies have indicated a sharp demand slowdown for products, such as PCs and gaming. The PC demand slowdown has been well-communicated, along with inventory challenges, while some segments remain solid. AMD (AMD) negatively pre-announced with much lower Q3 revenues than prior forecast. Taiwan Semiconductor (TSMC) posted their strongest growth in two years, but their forward outlook is much more conservative, and they are cutting capex 10% in anticipation of an industry decline. This comes on the heels of Micron’s (MU) 50% capex cut to wafer fab equipment.
Lower guidance is not consolidated just to semiconductors; Levi Strauss (LEVI) beat earnings forecasts and then lowered guidance. Similarly, McCormick & Co. (MKC) reported +3% y/y sales growth, but guidance disappointed and the company continues to incur elevated costs and supply chain challenges. LEVI has been discounting prices to help manage a surplus in inventory, while MKC indicated continued price hikes in order to fully offset inflation over time. Walgreens (WBA) beat expectations but experienced a sharp annual slowdown in earnings and revenues, and will continue to face headwinds from the strong U.S. dollar. WBA is leaning on their core health care business to drive solid growth and leveraging recent M&A activity to help them get there.
Many analysts are calling conservative guidance, “prudent” and that’s in line with our own expectations, which is that management teams will not stick their necks out in a slowing, high-inflation economy by offering aggressive outlooks. One consumer staple that did not follow this trend, and raised guidance, is PepsiCo (PEP), which beat expectations and then raised its full-year outlook after strong +16% y/y organic sales growth, and +14% y/y EPS growth, citing positive consumer trends. PEP has done a lot to transform their portfolio of products, and it’s paying off with consumer demand. They are also benefitting from a larger market share and greater control over their supply chain.
Lastly, many financials are reporting later this week, and BlackRock (BLK) was one of the first to announce. They are following the trend of beating expectations, but reporting a sharp decrease in earnings, -16% y/y. Inflows slowed significantly, in line with lower investor sentiment and lower asset prices overall.
Emerging Themes
We think demand for services continues to have more fuel in the slowing economy than demand for goods. This is exemplified with the contrasting earnings across airlines and semiconductors. It’s also
apparent in ISM figures that service-driven activity is expanding more than goods-producers. It’s important to note that both goods and services continue to have pricing power as indicated by CPI
data and market leaders, like PEP, reporting strong demand and organic sales growth.
Expectations are low for Q3 – according to FactSet, the consensus is +2.2% y/y EPS growth for the S&P 500, compared to +10.7% at the start of the quarter and +40% realized EPS growth in 3Q21. For this reason, we expect quality companies with pricing power to beat low expectations, despite slow or negative annual growth for most of the S&P 500.
While markets rallied on the CPI news, our opinion remains that the markets will continue in a choppy trading range. There are still many unknowns, and the old adage comes to mind: “Don’t fight the Fed.”
After yesterday’s report, the Fed will remain hawkish.