TS Lombard with the note:
- Not all inflation periods are created equal: when inflation is “demand-pull”(pro-cyclical), corporates are able to pass on PPI increases to customers.
- Historically, margins improve when inflation is pro-cyclical and contract when it is counter-cyclical.
- The current regime is pro-cyclical; we remain positive on margins and equities.
Rising input costs do not necessarily mean weaker corporate profitability. Producer prices have been surging globally: the US PPI now stands at a record 8.6% YoY. Recent market headlines have focused on the risk posed by these rising input costs to margins and thus equity prices. While this has certainly been a threat at times (e.g.,in the late 1970s and early 1980s), it is not always the case. Whether margins are eroded depends on the ability of firms to pass on rising input costs to their customers.
Firms sometimes try to hide these price increases through tactics like shrinkflation – where companies reduce the size of the product but charge the same price – but larger PPI increases require consumer prices to be raised to a noticeable extent. Whether consumers accept these larger rises (i.e., they continue buying goods and services at the same pace) depends on the resilience of demand, which, in turn, is a function of economic growth.
Not all inflation periods are created equal. Inflationary episodes can be broadly divided into two categories: pro-cyclical (i.e., demand-pull) or counter-cyclical (i.e., cost-push). In pro-cyclical inflationary periods, strong growth pushed up consumer demand to a level that stretches the ability of companies to supply the market efficiently; suppliers, for their part, increase prices. Price rises are a sign of a well-functioning expanding economy. By contrast, counter-cyclical inflation tends to be a result of rising input costs with no corresponding rise in aggregate demand. Historically, they have been induced by a supply shock (oil has been the culprit in recent years) and are generally associated with slowing or even negative GDP growth.
We define past inflationary regimes to evaluate margin performance based on the type of inflation (see table above). Looking at inflationary periods since the 1970s, we take nine inflationary episodes, which we characterize as either cost-push or demand-pull based on the following factors: (1) change in average hourly earnings, (2) commodity prices, (3) real GDP and (4) output gap. We also consider whether the period is pre-or post-recession. As one would expect, the 1970s and 1980s were characterized by cost-push inflation, while the decades since have largely been characterized by demand-pull inflation.
Current inflation is pro-cyclical. While it has long been our stance that the current inflation regime is pro-cyclical: it is worth noting that from the trough in the US CPI in May 2020, real GDP YoY has risen 14% and the output gap improved by 10 percentage points, against a post recessionary backdrop. CPI is at a 20-year high, but that has not negatively impacted retail sales, which today stand at 16.3% YoY in the US.
Margins improve when inflation is pro-cyclical. A look at margin performance within these inflationary regimes confirms our intuition: margins improve when inflation is demand-pull and fall when inflation is cost-push. In demand-pull inflation regimes, producers are able to pass on rising input costs to consumers and that is what we are seeing currently. The Q3 financial results exceeded expectations in both the US and Europe–for both revenues and profits–despite consensus forecasts being very demanding. Corporates are paying higher wages and paying more for raw materials, but they are passing these cost increases onto customers. Company accounts from Q3 earnings calls, report that the push back over steep price increases was no stronger than it has been historically.
These cost increases are being met by intense demand, allowing corporate profitability to rise. Margins bottomed across developed markets in January of this year and have risen since (see charts below).In fact, profit margins are close to the highs across DM and well above long-term averages. Additionally, strong margins are broad-based; margin breadth within each equity index (% of companies with margins above their 10Y average) is–in descending order of breadth–78% for SPX, 71% for NKY, 64% for SXXE and 58% for UKX.
Equities have positive returns when inflation is pro-cyclical. This is a topic on which we have opined before, with our view specifically for equities being that they are real assets and thus relatively indifferent to inflation. For equities, it is growth that matters. A look at regional equity performance within our inflationary regimes confirms that assertion (see top-right chart). Commodities perform well across all regimes but – again, in line with our original analysis – equities are, in fact, a better demand-pull inflation hedge than gold.
The macro backdrop remains positive for margins and equities. For sure, 2022 will be a more challenging year for equities than 2021, as growth normalizes and many central banks – including the Fed – tighten. But we expect growth to be materially above potential in 2022, which means that above – trend EPS and margin estimates are reasonable. Additionally, we expect normalizing aggregate demand and a falling yuan to eventually push inflation back down, reducing the cost pressure on corporates.