Run, Bull, Run

Stocks have been on a run lately, which is quite a contrast to what occurred at the start of the year. The S&P 500 dropped 6.2% from February until May. Since May, the S&P 500 has increased by 9.3%. Nowhere was this true more than in the consumer staples sector, which also is a particularly important sector for our portfolio. The consumer staples sector dropped 11.4% from February to May and has increased by 7.7% since May. There are of course many, many factors behind this turnaround, but one of the most important has been a change in the ability of firms to increase prices.

Earlier this year, we specifically talked about the significant drop that the consumer staples sector had experienced. We also discussed that the main reason for this was accelerating raw materials prices these firms were seeing in combination with an inability to pass on price increases to consumers. During the 4th Quarter earnings announcements, several firms in this sector specifically talked about the difficulty of passing on the increasing input costs they were seeing to their customers.

The inability to raise prices has been a characteristic that firms in virtually all sectors of the economy have been experiencing for the last ten years. The difference up until the 4th Quarter of last year was that they weren’t experiencing an increase in their input prices, so they were able to maintain their profit margins.

However, since the 4th Quarter of last year, firms have been seeing their input costs accelerating upward. This was seen clearly both in raw materials unit costs (such as purchase price indices) as well as unit labor costs (such as employment cost indices). But without the ability to pass on these price increases, we got profit warnings during 4th Quarter earnings announcements from a number of firms reflecting their expectations for the rest of this year. And stock prices took a tumble.

This situation seems to have reversed itself. In the most recent earnings announcements (2nd Quarter earnings announcements), firms have been reporting that they are now seeing greater ability to increase prices. To put it another way, they were reporting greater tolerance from their customers (and consumers ultimately) for price increases. At their July 31-Aug. 1 meeting, the Federal Reserve governors noted the return of pricing power in their meeting minutes. The Fed is of course carefully monitoring the return of pricing power because this is also an indicator of an uptick in inflation, the number one priority for the Fed.

For firms, the ability to raise prices means higher profit margins. The operating profit margins of firms in the S&P 500 have gone from 8.5% at the start of the year to 10.5% in the most recent earnings announcement period. And this is perhaps the single most important reason that we have seen the run-up in stock prices recently.

The really interesting question that the markets are now contemplating is what is going to happen with inflation as a result of firms increasing prices at a faster pace. Interestingly, from the latest Federal Open Markets Committee (FOMC) minutes, there doesn’t seem to be much of a sense of urgency. In the past, the blowout 2nd Quarter GDP report (4%+ growth) in conjunction with robust 2nd Quarter earnings and record-low unemployment would have prompted aggressive action by the Fed. However, in his recent Jackson Hole speech, Chairman Powell talked about taking a gradual approach to raising interest rates to combat inflation.

Inflation risk is one of the biggest factors driving most non-equity financial markets, from interest rates to exchange rates and commodity prices. It is through these markets that inflation subsequently affects equity markets. But with the ability to raise prices, equity prices should be hedged to the effects of inflation volatility.