Inflation Sticking Around, but Patience Is Warranted

It was a busy week in markets, so this week we’re just going to dive right in.

Wall Street Wrap

Powell Says Inflation May Be Stickier Than Forecast: “Supply-side constraints have gotten worse. The risks are clearly now to longer and more-persistent bottlenecks, and thus to higher inflation.”

That was the lead comment from Federal Reserve Chairman Jerome Powell, who shared a fresh take on the economy during a virtual conference Friday with the Bank of International Settlements. Markets already on edge about inflationary pressures glommed onto that bit, but let’s take a step back. Sure, Powell is conceding that inflation may remain elevated longer than anticipated, but the economy is complex, and supply chains are intricate — these things aren’t as easy to forecast as the weather. Just because prices may remain elevated longer than expected doesn’t mean the trend is no longer “transitory,” which is a relative term.

As we’ve said before, inflation is not a product of time; it’s a product of economic fundamentals. Simply put, the fundamentals don’t support inflation sticking above the Fed’s 2 percent target for a sustained amount of time. Inflation occurs when demand exceeds the economy’s productive capacity, but numerous signals show we aren’t there yet. We have an ample labor pool that’s more motivated to come off the sidelines and find work, given enhanced benefits have expired and savings are being drawn down. Producers also have idle capacity that can be “turned on” to increase productivity. Technological advancements in automation will further enhance productivity over time.

There’s a tendency to take the present situation and assume it will become the norm for the foreseeable future, but we encourage investors to remain patient. We are confident the underlying forces driving prices higher for now will be sorted out, and supply and demand will normalize. What’s more, if you’re invested for the long term in a well-diversified portfolio, you already have allocations to asset classes that work as inflationary hedges.

Earnings Proving Resilient: For months sentiment has been hit by inflation, COVID-19, supply chain issues and labor costs. How did it translate to the bottom line? So far, 117 of the S&P 500 companies have reported, and here are a few takeaways:

• In aggregate, top-line sales are roughly 16 percent above Q3 2020, and 66 percent of companies have reported sales above estimates (inflation-sensitive, commodity-driven industries reported the highest growth).
• Top-line growth has been strong enough to absorb higher input costs and still expand margins.
• Earnings growth is 46 percent above Q3 2020.
• American Express, Bank of America and JP Morgan Chase all highlighted the strength and resiliency of their retail customer base.
• Liquidity is strong, and building and loan demand is picking up to finance capital expenditures, inventory replenishment and strategic moves such as mergers and acquisitions.

Estimates for full-year earnings in 2021 have increased by 24.5 percent since the beginning of the year, and 2021 has been the strongest year for earnings revisions in 30 years. All in all, very positive numbers are coming from corporate America.

Growth Despite Headwinds: U.S. businesses logged a sharp, accelerated upturn in output in October, led by the services sector. The IHS Markit services PMI rose to 58.2 in October, up from 54.9 in September (any read above 50 indicates expansion). Overall, the composite PMI (manufacturing and services combined) hit 57.3, a three-month high.

Backlogs are building, and new orders are strong, but material and labor shortages remain the sticking point for businesses. The pressures on business capacity led to price increases and made it difficult for companies to work through the volume of sales coming in the door. But there’s good news: Companies raised their workforce numbers at the quickest rate since June during the month, which should help chip away at demand.

Supply Snarls, Prices Slow Pace of Growth Overseas: Supply bottlenecks and higher prices hit eurozone businesses in October, as well. However, the headwinds were enough to cause a deceleration in growth, pulling the composite PMI to 54.3 in October from 56.2 the month prior. Growth slowed sharply in Germany (though manufacturing was down just a click, from 58.6 to 58.5 in September), down to the lowest since February, and it slipped to the weakest since April in France. In the U.K. business activity accelerated at its fasted pace in three months, led by the services sector. Keep in mind, output and activity is still growing, but the headwinds we’ve cited above are slowing the pace. Encouragingly, job creation accelerated in the eurozone at its highest pace in 21 years as firms in the region boosted capacity to meet demand.

The Week Ahead

A Big Week for Tech Earnings: In general, it’ll be a packed week of earnings disclosures, with 164 companies in the S&P 500 (by market cap) reporting. Mega-tech (comprising 22 percent of the entire index) will take the spotlight, as Facebook, Google, Amazon, Apple and Microsoft are all set to report.

The Rest in a Busy Week: In addition to a flurry of earnings reports, it’s going to be another big week for key economy data points. Q3 GDP is due this week, along with personal consumption expenditures (PCE). GDP will be a key measure of economic growth, and expectations are for 2.8 percent. That’s a relatively weak read, but it will likely reflect COVID-19 and supply chain snarls (we’ll also pull in leading economic indicators to contrast GDP with some forward-looking data). PCE, particularly Core PCE, will be a big one for markets given the attention to inflation. Core PCE is also the Fed’s preferred inflation gauge. Consumer confidence is another key report hitting this week. This one, perhaps, takes on added importance as we head into prime spending months with the holidays on tap.

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