Profit margins, an oasis in volatile markets
Fortune favors companies that can pass on cost increases.
Several meetings this week, all virtual. Some weeks, wearing my slippers. Some weeks, my heels—ideal for me! Pandemic-driven changes, such as work-from-home and automation, are becoming engrained in our workforce, business models (and shopping habits—every minute on the internet, 6 million people are shopping online). Goldman Sachs counts 600 million fewer hours spent commuting every month, and 1.4 million fewer cashiers, in-person salespeople and office maintenance staff whose hours are being reallocated to more productive uses. It’s also estimated that $900 billion of home offices and $300 billion of consumer IT equipment are now available for business use, echoing ride-sharing’s productivity boom in the past decade, when Uber and Lyft monetized the household capital stock of cars. These changes are benefitting margins and creating a longer runway for the expansion. Indeed, as the earnings season suggests, corporate margins for the most part are holding up in the face of rising inflation and wages. Procter & Gamble said its customers are absorbing price increases (it helps when their pay is going up), and JP Morgan’s margin proxy—the difference between corporate intentions to raise prices vs. intentions to raise wages—suggests margins could possibly even widen. This is bullish.
Earnings and stock prices historically have tended to move directionally with inflation and the early stages of a Fed rate-hike cycle. In fact, S&P 500 earnings expectations have risen most rapidly when the Fed’s hiking but still accommodative, and when hiring, lending, spending and nominal GDP growth are strong. This sounds a lot like the situation now. BCA Research says periods of above-trend growth and Fed hikes have produced the best returns of any macro phase in the 42 years that earnings expectations have been compiled. The issue for markets generally isn’t when policy rates start rising, but how fast and by how much. Measured quarter-point hikes could be well received if appropriately telegraphed—the Fed’s signaling up to four this year, though the run-up in 1-year Treasury yields 12 months out suggests the market may be pricing in five. Cornerstone Macro puts even odds on inflation moderating sooner than expected, allowing Chair Powell et al to hold at just three hikes this year. This isn’t priced in and stocks would love that. On the flip side, also not priced in is a Fed policy mistake, such as a surprise 50-point hike. History shows the policy-setting FOMC prefers to surprise when lowering rates, not raising them. The Fed should lay out its thinking next week at the first meeting of the year.
Sentiment readings are becoming more bearish—AAII bull levels are at 3-year lows—although momentum as reflected in S&P, Nasdaq and Russell 2000 charts does not yet appear to suggest an oversold market. Strong credit conditions, low recession odds and extremely elevated equity risk premia continue to support Value, which relative to Growth, is off to its best start to a year in 30 years. The run-up in Energy and coinciding fall in Tech is a big reason. Energy leads Tech by 23 percentage points year-to-date—short-term stretched. But with Value still trailing Growth by 1.3 standard deviations, there seems to be room left in this trade. It helps that cyclical Value margins tend to hold up against rising inflation and rates—a view reinforced so far this earnings season, with Value stocks delivering stronger earnings-per-share (EPS) growth on margin improvement. Bank of America expects cyclicals EPS to grow five times faster than secular growth stocks this year and sees the Value trade continuing through 2023 on still cheaper valuations and a resilience to rising yields. During tightening cycles, cyclical stocks have tended to outperform 80% of the time vs. 40% of time for secular growth. The key is margins. If they hold up, the market should too.
- Housing’s got supply issues Existing home sales soared to a 15-year high in 2021, despite ending the year with a thud as record-low supply frustrated would-be buyers, causing sales to drop to a 4-month low. Builders are rushing to fill the void—December starts and permits jumped to their highest levels since last winter—and NAHB builder sentiment remained near a 10-month high. Purchase applications also are climbing—up 8% in the latest week—despite rising mortgage rates.
- New York’s an outlier Any worries about the surprise contraction in January’s Empire manufacturing gauge (below) were eased by the Philly Fed’s regional gauge, which jumped far more than expected off December’s 1-year low. Increases in activity, shipments and new orders drove performance. Also, the Conference Board today said leading indicators rose above forecasts.
- As goes Germany? Despite rising prices and plunging jobless rates in developed markets—Canada, Western Europe and Australia are back at pre-pandemic levels—a wage-price spiral seems unlikely. In influential Germany, the largest economy in the eurozone, half of German employees are covered by union-negotiated pay agreements whose structure limits wage increases. Last year, their negotiated wages rose an average of just 1.5% year-over-year (y/y) and new talks aren’t scheduled until late this year.
- Wages are the biggest threat to corporate margins Warning that “wage inflation is everywhere,” Goldman Sachs said its compensation costs jumped 33% last year. Other major banks said they’re having to pay up, too. Almost two-thirds of corporate costs come from the labor market, where wage growth is at a 30-year high. With the percentage of companies looking to raise wages and the percentage reporting labor shortages or voluntary quits close to all-time highs, wage pressures are unlikely to ease.
- The omicron effect Evercore ISI’s weekly retail sales survey plunged the past two weeks as the virus kept shoppers and workers away, and weekly jobless claims surged to a 3-month high, in part because half of states let workers file for benefits if omicron keeps them from work. Also, January’s Empire gauge unexpectedly contracted as the variant’s spread through New York slashed activity.
- Inflation is sticky After quadrupling to 7% the past 12 months, y/y CPI is worsening, with Q4 2021’s trend hitting 9.1% and price increases broadening beyond cars and rents. Over the next several months, y/y prints are likely to escalate further as weaker year-ago readings roll off. It’s not just in the U.S. U.K. inflation is at a 30-year high and oil prices are at a 7-year high.
Cryptocurrencies demystified The universe of stablecoins—cryptocurrencies that derive their value from underlying assets such as the U.S. dollar or gold—is approaching $170 billion, up from less than $30 billion at the start of 2021. JP Morgan says it could grow $700 billion over the next five years as stablecoins’ usage for payments grows.
Not so happy anniversary In a week marking President Biden’s first year in office, polls showed his popularity at an all-time low 41.9%, the second lowest of all post-war presidents at the 1-year mark, with only predecessor President Trump’s worse (39.5%). The good news: approval ratings at the one-year mark aren’t particularly well correlated with the odds of re-election.
China, another big risk The latest housing-focused news flow emanating from China suggests its residential construction slowdown has further to run, with all that implies for the wider economy. And its zero-Covid policy, in the presence of a contagious variant, continues to have implications for the global economy as lockdowns are threatening additional supply bottlenecks at an inopportune time.