Another hot print on consumer prices has Wall Street once again on edge. The headline question is whether inflation will recede before the Fed is forced to choke the economy with interest rates.
At this point, investors fear the Fed. For one thing, higher financing costs will make it harder for companies to borrow to fund growth initiatives while also making it harder for their customers to buy on credit.
And every uptick on bond yields naturally lowers the ceiling on what Wall Street will pay for every dollar of earnings. While we don’t know the ultimate limit yet, we’ve definitely been trained to sell high multiples whenever it looks like the Fed will get more aggressive.
High inflation means higher interest rates, which mean slower corporate growth and lower patience with stocks that can’t justify every penny of their price. It’s not a cheerful situation for investors.
Add the pent-up frustration that we all feel on Main Street with higher bills and precarious portfolio returns, and the mood is brittle at best. But sad to say, persistent inflation has another impact on the market.
Corporate earnings are reported in current dollars. When purchasing power is relatively stable, that’s not a big problem: a dollar today will be worth roughly a dollar a year from now, and both will more or less match what the currency could buy a year ago.
Inflation bends the math. In a year that prices climb 8%, companies (like households) need to run faster to make any progress. If they manage to grow faster than inflation, it just doesn’t feel like such an achievement.
And if they aren’t staying ahead of inflation, then even a decent growth rate on paper still feels like shrinkage. The dollars coming in buy less and are worth less. They’re smaller than they were a year ago.
You’re raking in more dollars. But in real terms, you’re going in the wrong direction.
We can tolerate a little scattered inflation as investors and as consumers. But it’s starting to sting.
Prices started to spike in April 2020, almost exactly two years ago. Since then, the raw CPI has taken 12% of purchasing power out of every dollar. That’s not just dollars we spend. It’s dollars we earn.
The Rest Of The Story
Corporate earnings targets are quoted in current dollars as well. Factor anticipated inflation against anticipated growth and the coming year won’t feel nearly as good as it does on paper.
The Fed optimistically thinks it can get inflation down to 4% by the end of the year. Wall Street would be shocked to see prices slow below an annualized rate of 6% or so.
Subtract 4-6 percentage points from anticipated growth and you have the real rate at which earnings are likely to expand this year. Suddenly robust 10% richer earnings on the S&P 500 on paper feels miserly.
We can cheer 10% real earnings growth. When the headline number gets down to 6% (if the Fed is on track) or 4% (Wall Street’s current realistic scenario), the math gets a lot less attractive.
Some sectors look better than others, but odds are now good that a wide swathe of the market will report negative real earnings growth this year. They’re working harder, running faster. On paper, they’re keeping up.
It just won’t feel that way. I’m talking about companies that rarely grow fast even in ideal conditions: utilities, communications, consumer staples, even healthcare. The financials, already poised to see earnings drop 10% this year, become a truly miserable prospect.
Nobody likes to buy a company that’s going the wrong direction. In real terms, I’ve just listed 45% of the S&P 500 as heading underwater this year.
If this is the shape of the post-COVID economy, it’s too hot for real comfort. Going back two years, we probably need to scale all earnings comparisons back about 19 percentage points to get a real sense of where areas of the market have gone . . . and where they’re going.
Energy has obviously become an essential component of many portfolios this year, but the base is pitifully low. These companies were left for dead in 2020 and 2021, so even if earnings double in 2022 they’re still trailing the rest of the economy.
Materials companies are in the sweet spot. Demand for essential commodities never really went away, and every inflationary burst gets passed back down the consumption chain. On average, these companies are on track to boost their bottom line 67% between 2000 and 2022 . . . in real, after-inflation terms.
It also feels like a boom for tech and real estate. As I mentioned, healthcare, consumer staples and finance are looking a little shakier this year. Their best days of peak pandemic are behind them.
And subtract Amazon from the consumer discretionary sector and the erosion is stark. Even counting Amazon, earnings there have cratered 35% since COVID changed the economy and started the inflation clock ticking louder.
There’s value in deteriorating sectors but on the whole, if you follow earnings comparisons, the playbook is fairly clear here. Buy growth at a reasonable price. Buy deterioration at a deep discount. Avoid paying too much for anything.
After all, isn’t that what we do as consumers in an inflationary environment? Let that be your guide here.