Inflation Has Started: How Long Does it Continue and How Does it End?

What We’re Seeing (Economic Data) and What We’re Hearing (Earnings Reports)

October economic data broadly indicated a rebound in growth from September and we expect this growth trend to carry momentum into 2022; however, stronger growth also drives inflation. Better economic data included ISM Services hitting a record high expansion number of 66.7 – its 17^th consecutive month of growth. There was also positive surprise in durable orders (ex-auto and factory orders). We continue to stress how wage inflation is more sticky than the supply chain disruptions; we received some staggering wage and payroll numbers, as companies compete for employees. Due to the lack of labor and supply, productivity retreated -5.0% in Q3, while unit labor costs increased +8.3%. On top of higher wages, the Producer Price Index (PPI) remains elevated at +8.6% y/y. These higher costs indicate 1) the significant level of demand and 2) the pricing power companies maintain in order to absorb those costs.

Virtually all companies are adapting to inflationary pressures in the current quarter, while also anticipating continued pressures ahead. Boeing Company (BA) stated that “evidence is beginning to support, that by H2 next year, our industry will be supply constrained.” Aptiv PLC (APTV), impacted by chip shortages, said that “we’re not treating the inflation as transitory.” McDonald’s Corporation (MCD) says “there is wage inflation. Our franchises are increasing wages… we’re up over 15% on wages.” And DOW Inc. (DOW) said “these supply chain disruptions are expected to persist, which will certainly prolong the ability to restock inventories across most value chains. As a result, we expect tighter-than-forecasted market conditions to continue.”

In addition to the anecdotal comments around cost pressure and supply chain disruptions, there are many additional ways that strength in demand is driving growth. So, while we continue to build a thesis that indicates a strong demand economy and rising inflation, how long can these dynamics persist? We believe quite a while longer.

Return of the Services Sector

The pandemic and lingering variants have impacted services for a longer time period, relative to goods. As consumers remained hesitant to dine out or travel, they spent excess liquidity on at-home goods. Now, it appears that services share of GDP has bottomed and is finally trending upward. Increased demand for services, along with hiring and wages, will push prices higher.¹ And they’re already running high – CPI Services (less energy services) reached +3.2% y/y growth. Expedia (EXPE) stated in their earnings call that they’re “already seeing better bookings for next summer than we saw this time last year.”

Widespread demand for goods has driven many of the supply chain disruptions as supplier delivery times increase – reaching 74% in October (its highest level since 1974 and trending higher). Company backlogs (another indication of high demand and labor tightness) remain elevated, with little to no improvement from Q2, due to supply and labor constraints. CPI reached +6.2% y/y growth in October, its highest acceleration since 1990. Even considering an improvement in supply chain disruptions, higher prices are likely to persist because of the extensive backlogs, lead times and longer-term materials shortages.² It is important to note that labor tightness is improving with the higher wages and end of government stimulus – initial unemployment claims are reaching new lows every week and non-farm payrolls increased +531,000 jobs in October (its highest increase since July).

“Services”, as a percent of GDP, is historically near 70%. If demand for goods normalizes after the seasonally strong Q4, services, driven by the reopening, will be there to push prices higher with solid magnitude.

Where is the Tightening?

Normally, inflationary price pressure is met with tightening monetary policy. However, this is difficult to achieve, given the stretched equity valuations in the market – many of which are derived from forward-looking earnings. This matters because the attractive equity market is compounding at record rates, partially because of the artificially low interest rates in the bond market. This creates an artificially low cost of capital and encourages corporate growth and higher valuations. Typically, as soon as rates rise that cost of capital goes up, forward earnings are adjusted downward and you’re due for a correction in the equity markets. Interestingly, the opposite has happened and rates have actually gone lower since the Fed announced the start of a taper schedule at last week’s dovish FOMC meeting.

Bond markets have shown significant volatility lately as they grapple with rising inflation paired with continuing easy monetary policy and reluctance by the Fed to address rate hikes. The Bank of England also balked at raising interest rates when it was widely expected that they would during a meeting last week. We anticipate a steeper yield curve and continued volatility in bond markets.

The Need for Companies to Invest in Productivity.

In Q3, annualized productivity fell to its lowest rate ever (-5.0%) as annualized unit labor costs (+8.3%) and ISM supplier deliveries, order backlogs and prices all grew. With companies reporting significant free cash flow figures in Q3 (and expecting record full-year numbers) – they’re using the moment to improve balance sheets and return cash to shareholders. Given this setup, we expect a capex boom in 2022. Whether that capex boom is driven by demand, competition, infrastructure stimulus, or all the above, the pandemic recovery has prioritized corporate need for efficient supply chains and logistics, especially amid the higher inflationary costs that are expected to remain. We expect companies will invest to become more efficient with improved sourcing, freight usage, build rates, energy consumption, product mix etc. to offset the cost of labor and certain materials that will remain elevated. Companies will need to innovate their current operations to be more automated, algorithmic and predictive.

ISM Manufacturing Statistics and Labor Statistics³

There’s a handful of themes that we believe different sectors will be investing in to improve productivity. Industrial companies are focused on investing in their high-margin software solutions that use algorithms and machine-learning to create efficiencies. Retail companies are building new facilities and warehouses to meet the changing demand environment, with some also investing in their own logistics. Freight and manufacturing are are investing in automation. Consumer staples are improving and diversifying their sourcing. Real estate is investing in additional capacity and better materials sourcing. Energy is investing in a transition to renewables. Technology is investing in their enterprise solutions and cloud-based apps. Health care is investing in their pipelines.

The fundamentals and economic recovery environment for equities are strong. High demand has allowed companies to generate better free cash flows and they’ve improved balance sheets and returned cash to shareholders. While doing this, they’ve also incurred higher costs (both transitory and non-transitory) as part of the cyclical recovery. When supply chain disruptions and labor tightness ease in 2022, there will be an emphasis on improving operating efficiency via capex to offset some of the stickier components of inflation. Efficiency gains, from better labor and capacity utilization, should allow prices and total costs to normalize.

Stephanie Link: CNBC TV Schedule

Sources:

1. Natixis (charts)
2. Natixis
3. Natixis (charts)
4. FactSet (chart)

Disclosures:

Investment Solutions at Hightower Advisors is a team of investment professionals registered with Hightower Securities, LLC, member FINRA/SIPC, & Hightower Advisors, LLC a registered investment advisor with the SEC. All securities are offered through Hightower Securities, LLC and advisory services are offered through Hightower Advisors, LLC. This is not an offer to buy or sell securities. No investment process is free of risk and there is no guarantee that the investment process described herein will be profitable. Investors may lose all of their investments. Past performance is not indicative of current or future performance and is not a guarantee. In preparing these materials, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public and internal sources; as such, neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Hightower shall not in any way be liable for claims and make no expressed or implied representations or warranties as to their accuracy or completeness or for statements or errors contained in or omissions from them. This document was created for informational purposes only; the opinions expressed are solely those of the author, and do not represent those of Hightower Advisors, LLC or any of its affiliates.