Inflation Is Alive and Well and Living in S&P 500 Income Statements

(Bloomberg) -- The Federal Reserve may not see much inflation, but the stock market sure can, and its whereabouts helps explain why enthusiasm for equities continues to build.

To find it you must drill into the earnings statements of American companies -- beyond sales and earnings and down to the lines that track profitability and pricing power. It’s in the row labeled gross margin, which the terminal defines as the percentage of revenue a company keeps after the costs of producing the goods and services they sell.

Long story short, for the majority of S&P 500 constituents, it’s going up, evidence most companies still are managing to raise prices faster than wages and raw material costs eat into sales. To some it’s an incipient inflation harbinger, though one that along with rising sales helps explain why analysts see another year of earnings growth in the benchmark index. Combine it with a Fed that is all but committed to holding rates steady for the rest of 2019, and it becomes a recipe for rational exuberance among risk-loving investors.

“S&P 500 gross margins show companies aren’t having too much trouble passing prices on to consumers despite the evident slowdown in global growth last fall,” wrote Bloomberg Intelligence analysts led by chief equity strategist Gina Martin Adams. “Pricing power is intact, implying inflation may be ‘stickier’ than is ideal for a shift to dovish Fed policy.”

Inflation Is Alive and Well and Living in S&P 500 Income Statements

That’s the rub, that what’s good for earnings and great for investors might contain the seeds of doom for the Fed’s suddenly stimulative stance somewhere down the line. “S&P 500 gross margins don’t correlate perfectly with economic measures of inflation, but peaks have historically led peaks in U.S. consumer price inflation by 6-12 months,” Adams’s team wrote.

That aside, the trend in gross margin is one of the few bull cases left on corporate profits, on the eve of a first-quarter earnings season that may show the biggest drop for S&P 500 profits in three years. More than 200 companies in the index are expected to say they earned less than a year ago when they disclose results, starting with banks about three weeks from today. This follows a rally that started on Christmas Eve that has added about $4 trillion to the benchmark’s market value.

Analysts estimate the profitability measure should rise for 53 percent of S&P 500 companies over the next 12 months, Bloomberg Intelligence data show, with energy, technology, and consumer discretionary stocks seeing the strongest ability to raise prices.

Outside of corporate P&Ls, stubbornly low inflation helped prompt the Fed’s 180-degree turn earlier this week. At its latest meeting, policy makers signaled there will be no rate hikes the rest of the year. Chairman Jerome Powell then reiterated patience in the press conference, saying: “It may be some time before the outlook for jobs and inflation calls clearly for a change in policy.”

Inflation Is Alive and Well and Living in S&P 500 Income Statements

To be sure, the pricing-power bounty is not ubiquitous, with just over half of S&P 500 constituents succeeding in passing costs along. For Goldman Sachs, that makes now a time for investors to exercise discretion.

“Although, from a corporate perspective, inflation represents higher prices charged to customers, firms are already struggling to pass through rising input costs,” Goldman strategists led by David Kostin, wrote to clients. “With margin pressures large and mounting, the equity market is rewarding firms with the pricing power to maintain their profits.”

A basket of companies with the best record of raising prices has beaten its counterpart by more than 15 percent since last May, Goldman Sachs data show. The outperformance has accelerated this year as the Fed signaled it’s willing to tolerate higher inflation.

Ellen Hazen, senior vice president and portfolio manager for F.L. Putnam, which manages $1.7 billion, says she’s staying away from investing in companies with stronger wage pressures right now. Currently, her team is cautious on retailers, consumer packaged goods companies, and homebuilders because “wages are rising and could crimp margins.”

At Ameriprise Financial, there’s a similar focus.

“Investors need to start looking at their portfolio and saying what kind of companies are going to continue to perform well as we get into the later stages of this economic cycle,” said Anthony Saglimbene, a global market strategist for the firm. “And I really do believe it’s quality-based companies that have competitive advantages and pricing power -- that they don’t see their profit margins or growth eroded simply because wage inflation is increasing.”

©2019 Bloomberg L.P.