“Why is everyone so happy about 8.5% inflation?” BofA’s Savita Subramanian wondered, adopting an incredulous cadence in the course of painting a somewhat grim picture for corporate America.
A fixture of most equity bull cases in 2022 entails describing stocks as an inflation hedge. But that only holds up to the extent corporates can pass along higher costs to consumers. That’s possible until it isn’t, at the risk of trafficking in tautologies.
Rising credit card balances appear to suggest at least some consumers have exhausted pandemic savings buffers and it’s probably just a matter of time before demand wanes further. Between the downward revision to the personal consumption component in Q1’s GDP report and a lackluster read on the consumer in the advance read for Q2, there’s already evidence to support the notion that no matter how “addicted” (as Michael Burry put it last week) Americans may be to spending, there’s a limit.
Outside of the pandemic-inspired plunge in 2020, Q2 2022’s personal consumption print was the lowest since the first quarter of 2019, a period impacted by the longest government shutdown in US history (figure above).
“Inflation helps when companies have pricing power amid strong demand, but companies have a harder time passing through higher costs when demand wanes,” BofA’s Subramanian said, adding that when it comes to costs, “rising wages are a bigger risk to corporate margins than PPI or commodities.”
For what it’s worth, stocks are the furthest thing from cheap, especially on the heels of a rally that pushed the Nasdaq up more than 20% from the June lows.
Relative to inflation, equities appear laughably expensive. “Based on the strong relationship between trailing P/E and CPI, today’s PE 19.4x implies 2.6% CPI,” Subramanian remarked. “And 8.5% CPI implies 11x on trailing P/E.”
You can do the simple math on that yourself. Put an 11 multiple on trailing, aggregate index-level profits and you’ll get an SPX level consistent with a Jeremy Grantham warning.
Subramanian also suggested market participants may be making a very basic mistake on the way to being almost comically derelict in appraising the outlook for corporates. “The refrain we hear from bulls is that corporates did better than expected in Q2,” she wrote, before sarcastically exclaiming that “the S&P 500 grew sales by 15%!”
Of course, a lot of that is down to energy companies which are experiencing a (dirty) renaissance thanks to soaring fossil fuel prices, but Subramanian’s larger point was that only 53% of S&P constituents grew sales in real terms, and adjusted for inflation, aggregate YoY sales growth for the index ex-energy was less than 1% (figure below).
Disconcertingly, Comms Services and Tech delivered negative real sales growth.
Does it make sense to assess the situation through this lens? In a word “yes.”
“Sales growth is easy when inflation is high, and the market figured this out in the 70s,” Subramanian went on to write, noting that during inflation cycles, the S&P 500’s Price to Sales ratio compressed by an average of 40%. By contrast, P/S has expanded by 15% since May of 2020.
“We may be assigning too much credit to sales,” Subramanian gently suggested. Last month, she cut the bank’s year-end S&P target to a Street-low 3,600. I think I can fairly call that bearish.
In the 1970’s, the real interest rates were positive, not negative- which provided a good alternative investment to stocks.
Today, real interest rates are negative.
Exactly! Putting your money in a CD yielding 3% is a negative rate of return taking 8.5% inflation into account.
True, but earning zero on cash is even worse! Something is better than nothing, even if it’s only a nominal return.
I appreciate and admire Savita Subramanian’s balanced perspective and assessments, which are useful.
I’m not into CDs. To me, obtaining worthwhile returns necessarily entails risk. I invest some of my resources in companies like BA and VZ when they drop to low levels. And dividends are nice, but don’t make me happy. I have always been a small-cap growth investor at heart. I work in technology, and I tend to invest in technology/small-cap growth.
When downturns have occurred over the years, I’ve ridden them out and profited. But honestly, this downturn feels different because it includes macro variables that can extend the downturn and discomfort.
If anything can encourage the likelihood of Subramanian’s S&P 3600 bearish year-end target, it’s the price of oil. The price of oil is lately moderating, but the price of oil is a big economic variable that is likely to rise again, and it can possibly be a burden for an extended time.
Strains in the supply of oil products to support the heating needs of western countries during the winter will likely trigger higher oil and inflation. While this is especially true in Europe, the US will probably also be negatively affected. On the other hand, the Ukrainians could bring Russia to its knees early next year, believe it or not, if all goes well. And any hint of an end to that war may help to resolve fuel supply issues for next summer.
It’s wishful thinking on my part, but it would be bullish if Russia, in effect, is compelled by unfavorable circumstances to negotiate for peace. Full disclosure, I’m rooting for Ukraine, and very much a partisan. But we can all agree that any further reductions in the price of oil will be good for the world economy. Hopefully, the Fed will also be done pouring cold water on everything by then.
The Ukrainians are not going to win (not that I wish against them) – they don’t have the resources. And the US does not have the resources – and I’m stating this after nearly 40 years of working in aerospace/defense, an industry which has gutted itself via extensive mergers and acquisitions, and has become quite Orwellian since the ’90s.
I agree with you about small-growth technology, and also have a preference for investing in that area. I’ve found some reasons for optimism on both the investing as well as employment front by looking at small growth tech.