Federated: Inflation Isn’t Killing The Bull…Yet

It’s not too early to be worried about inflation, but it’s too early to be bearish. The nearly completed Q3 earnings season (the sixth straight to surprise to the upside) shows companies thus far have been able to pass along rampant cost increases—and in some cases raise their prices even more—leading to record margins and higher revenues, both bullish for earnings. So, while inflation is clearly a risk heading into next year, we anticipate remaining constructive on stocks as long as margins and earnings growth continue to hold up.

That said, if inflation readings that are now at multidecade highs stay elevated and continue to broaden from such “transitory” categories as used cars and gloms on to wages, it’s going to be difficult for many companies to keep defending margins. Therefore, our focus increasingly is on investing in companies that have real pricing power, i.e., where demand for products and services tends to be relatively inelastic with economic and income growth accelerating as they are now. These names tend to fall in cyclical sectors of the market, such as Energy, Materials and Consumer Discretionary. One example: the price of chlorine for our pool jumped sixfold this summer. We could either pay it or do without the pool. With a house full of sweaty kids and parents working from home, we really had no choice. We paid the man.

Our bullish case for next year, with a price target of 5,300 on the S&P 500, remains tilted toward large and small-cap cyclical Value stocks precisely because of the pricing power of many companies in these areas. (We like dividend stocks, too, because unlike longer-maturity bonds, their coupon isn’t at risk of erosion if rates rise as typically occurs with higher inflation). On the other hand, defensive stocks, where goods tend to be commoditized and substitution is more common, may be unable to continue to pass along price increases, thus squeezing margins. Elevated inflation also can create difficulties for Growth stocks, not so much because they can’t pass on prices (when was the last time you saw smartphone prices slashed?) but because rising inflation tends to beget rising interest rates, which in turn discounts future cash flows and earnings, both key components of Growth stock valuations.

The critical player to watch in all this is the Fed. We think policymakers have been behind the curve, and this is a risk. A taper/rate-hike schedule that anticipated, rather than responded to, inflation would have made it easier for the central bank to move at a slower/gentler pace if inflation proves stickier than policymakers are saying it will. Such a proactive approach in the last several cycles helped the economy avoid inflation and supported longer expansions. But it appears too late for that. Instead, by potentially starting taper late (relative to today’s high inflation readings) and with rate liftoff unlikely until June at the earliest, there’s reason to be concerned about the potential for a faster, more disruptive rate cycle. It’s this concern that we’re monitoring closely. For now, however, we think there’s still room for inflation and certain sectors of the equity market to cohabitate somewhat peacefully.