While many investors had predicted low inflation for the year, so far inflation has come in higher than projected, and this has been a benefit for several corporations.
Companies have had to boost prices due to inflationary pressures as well. But if expenses are paid, it may be a plus. But if they are not, it is a negative.
“I think it’s a double-edged sword here,” said Brian Rauscher, Fundstrat’s head of global portfolio strategy. “Some will experience transitory input cost pressures. The world’s supply chains are still not fully operational.
“We’re going to have bottlenecks until we get the global machine up and running like it was pre-Covid,” he added. “In the short term, that is a drag on margins. On the other hand, companies have streamlined their operations as a result of Covid. They have expanded their operating margins.”
According to Rauscher, if rising input costs are only temporary, margins should be fine.
“What’s going to happen is that revenues for these guys will start to accelerate, and that’s what we’re going to focus on,” he said.
One major disruption is the semiconductor shortage, which is affecting the automotive and technology industries.
Even Apple is feeling the pinch of the shortage, which is reflected in revenue losses from iPad and Mac sales. Apple said on Wednesday that it expects its fiscal third-quarter sales to be $3 billion to $4 billion lower than they could be if supply issues were not an issue.
According to Bank of America, the S&P 500’s net margins are expected to fall by 20 basis points to 11.1 percent in the first quarter, possibly due to cost pressures.
However, the bank expects S&P 500 net margins to rise to 12.5 percent this year. This is higher than the Wall Street consensus of 12.1 percent. This represents a significant increase over net margins of 10.8 percent in 2020 and even 11.9 percent in 2019.
Kwon stated that margins were even higher in 2018, at 12.4 percent, before being impacted by trade wars in 2019.
“There is good and bad inflation,” he explained. “So far, it appears that inflation has been fairly good. Pricing power is held by businesses.”
Kwon added, “That could potentially reverse.” “As we look ahead to 2022, we believe the gap between winners and losers will widen. Companies with pricing power are better off.”
For the time being, earnings are skyrocketing, fueled by increased demand in the reopening economy and a comparison to last year’s weakness.
According to CFRA chief investment strategist Sam Stovall, first-quarter earnings growth is currently at 29.1 percent, which is more than double the forecast. Profit growth of more than 50% is expected in the second quarter.
“If share prices are being driven by the possibility that second-half earnings growth will be even stronger than expected, the concern is that we may be underestimating inflation growth,” he said.
According to Stovall, inflation has been largely positive thus far, allowing businesses to raise prices. He also stated that the level of inflation is not expected to rise significantly before it begins to fall.
When inflation becomes uncontrollable
However, there is concern that inflation will be hotter and last longer than economists – and the Federal Reserve – anticipate.
When inflation becomes a problem, businesses are unable to pass on rising costs, and margins erode.
“We highlighted the number of mentions of the word ‘inflation’ made by companies during earnings calls,” said Bank of America’s Kwon. “It has quadrupled since last year. It correlates with [the consumer price index], indicating a fairly robust increase in CPI.”
During the company’s earnings call, CFO Monish Patolawala stated, “Inflation is coming in faster.” He stated that the company is working with suppliers to minimize disruptions and that prices are being raised.
Organic volume growth, as well as cost management and productivity efforts, enabled 3M to increase operating margins.
“It will take some time for these actions to gain traction,” Patolawala said. “As a result, we anticipate a 75 to 125 basis point year-on-year operating margin headwind from selling prices, net of high raw material and logistics costs, in the second quarter.”
As inflation rises, there will be winners and losers.
According to Kwon, the sectors that perform best during inflationary periods are energy and materials. According to Bank of America, potential winners include Mosaic, Occidental Petroleum, Halliburton, and Exxon Mobil.
Micron Technology, Advanced Micro Devices, and Oracle are among the technology companies on the list.
In addition, the firm has a list of companies that are more negatively affected by inflation, such as Hershey and Campbell Soup, as well as retailers such as Amazon and Costco.
Kwon stated that Bank of America strategists anticipate margin pressure in the consumer discretionary sector as a result of rising labor costs. This was one of the reasons given by the bank for downgrading consumer discretionary stocks to underweight on Thursday.
According to Bank of America analysts, consumer discretionary margins will have recovered from 5.3 percent in 2020 to 6.5 percent this year and 7.3 percent by 2022, from 5.3 percent in 2020 to 6.5 percent this year and 7.3 percent by 2022. However, this is less than the 7.9 percent net margin predicted by Wall Street for the sector in 2022.
Restaurants are also classified as consumer discretionary.
On the company’s earnings conference call, Chipotle Mexican Grill CFO John Hartung discussed the impact of higher labor costs.
According to Hartung, a 10% increase in wages would reduce margins by 140 to 200 basis points. To make up for this with menu pricing, the company would have to raise prices by 2% to 3%.
“So, all of that is very, very manageable, and we believe that if there is significant increased inflation due to market-driven or federal minimum wage, we believe that everybody in the restaurant industry will have to pass those costs along to the customer,” he said.