Inflation Earnings Pressures Put Pricing Power in Driver’s Seat

Wall Street is rolling into the heart of earnings season with the hottest inflation print in more than a decade fresh in mind, putting a premium on companies best able to handle those price pressures.

Shares of companies with higher pricing power -- the capacity to pass on costs to customers without harming the business -- are on track to outperform those with low pricing power for a second straight month, according to baskets tracked by Goldman Sachs Group Inc. July has seen the biggest relative gain for high pricing power shares since March 2020, the start of the current bull market.

Whether the current burst of inflation proves transitory or not -- Federal Reserve Chairman Jerome Powell insisted again this week it would -- companies still have to manage the current jump in input costs. The ability to do so will be a key metric this season, as evidenced by Conagra Brands Inc. The foodmaker plunged 5.4% and was hit with two analyst downgrades after chief executive officer Sean Connolly warned of “atypical” inflation hitting the company’s margins.

“A key to success in investing in the second half of this year is to be long companies who have pricing power, who have more ability to manage their costs,” Kate Moore, BlackRock global allocation team head of thematic strategy, said in a Bloomberg Television interview. “Inflation is front-and-center in everyone’s mind, whether you’re a bond investor or an equity investor, as we go into this earnings season.”

Inflation Earnings Pressures Put Pricing Power in Driver’s Seat

Those companies that are able to pass on higher prices will likely be rewarded. Take Caterpillar Inc.: Goldman analysts this week recommended buying bullish call options on the stock ahead of its second-quarter earnings, due in part to the company’s “ability to pass on cost inflation through higher pricing.”

The obsession with pricing power could also help explain why the reflation trade has unraveled recently. The small-cap Russell 2000 Index, which dominated earlier this year as investors piled into reopening bets, saw its year-to-date gains against the Nasdaq 100 crumble this week.

In addition to a dramatic drop in Treasury yields, the fastest pickup in inflation since 2008 sparked fresh concern over the growth potential of smaller U.S. companies forced to contend with pricing pressures. Megacap tech shares, with their Teflon balance sheets, are seen as a safer bet in such an environment.

“Technology is an example of a sector that can have pricing power -- they have good balance sheets,” said Matt Miskin, co-chief investment strategist at John Hancock Investment Management. “The adoption we’ve seen post pandemic, it looks more sticky versus coming out of the pandemic.”

Of course, potential pricing power doesn’t mean a company will actually opt to pass on their higher costs. But it will still likely be an important sorting tool as investors seek to navigate earnings season, according to Giorgio Caputo.

“Some companies have a great deal of pricing power but they exercise it slowly because they’re trying to manage their own client relationships,” said Caputo, senior fund manager at J O Hambro Capital Management. “But definitely, the market will be very focused on pricing power and margins, and will likely reward businesses that are able to pass pricing through and maintain their profitability and grow earnings.”

©2021 Bloomberg L.P.

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