Soaring earnings, higher revenue and fewer profit warnings than usual—on the face of it the third-quarter results show corporate America is thriving.
But under the surface, there are worrying signs both that cost increases are starting to bite into profits and that investors are growing more concerned about inflation.
First, the good news: S&P 500 (.SPX) earnings are expected to be up 29% from a year ago by the end of the third-quarter reporting season, according to Refinitiv. That would be the biggest rise in eight years. With three-quarters of companies having produced their numbers, earnings have come in far higher than Wall Street’s already-strong forecasts. The proportion of downgraded guidance for future earnings compared with upgrades was also lower than usual. Business is humming.
The bad news is that costs are rising, with low unemployment pushing up wages at the same time that Donald Trump’s import tariffs feed through into higher input prices. Companies that can pass on higher costs to their customers will thrive, and help to push up wider inflation. Those that cannot will face squeezed profit margins, and an unpleasant outlook.
The reports from some of the big consumer companies show the contrast. Both Kraft Heinz (KHC) and Procter & Gamble (PG) were hit by sharp rises in trucking costs, as a shortage of drivers pushes up wages and fuel costs rise. But P&G managed to keep prices flat and increase sales, while Kraft had to cut prices to get about the same increase in volume.
P&G, like European rivals Nestlé (NSRGY) and Unilever (UN), plans to jack up prices in the coming months. But the company’s chief financial officer, Jon Moeller, emphasized the uncertainty about whether consumers would accept higher prices. “We’ll simply have to adjust as we go and as we learn,” he told analysts.
Something similar happened with tariffs, with many companies reporting that they had passed through the costs of the early rounds of import taxes to customers—costs that generally become higher input costs for other businesses. Illinois Tool Works (ITW) is among those confident it can pass on the higher tariffs it will pay next year, too, amounting to $60 million, on top of price rises to catch up with higher raw material costs. Bank of America Merrill Lynch analysts said on Monday that only around a third of companies mentioning tariffs in earnings calls said they were hitting profits, with more than half saying they were offset by price rises or cost cuts, or had only limited effects.
Wage rises aren’t confined to truck drivers. Darden Restaurants (DRI), owner of the Olive Garden chain, said it had upped wages by 5% to retain hourly workers as opportunities elsewhere improved. Data on Friday showed average earnings up 3.1% year-on-year in October, the fastest pace in almost a decade, as unemployment held steady at 3.7%, the lowest since 1969.
The scale of investor worries about inflation show up in stocks and bonds. For the best part of two decades shares and bond yields (which move inversely to prices) have tended to rise and fall together, as the prospects for economic growth ebb and flow. Because inflation was low and under control, more inflation was usually seen as good for shares, while always bad for bonds, so Treasury yields and stock prices moved together.
For the past few days stocks and bond yields have moved in opposite directions, suggesting worries that inflation will start to hurt stocks. Worse, since the start of October bonds have failed in their usual job of cushioning a portfolio during a stock selloff, with Treasurys losing money too. The danger is that we are shifting from an era where rising inflation was good for stocks, because it showed the economy was doing better, to an era where inflation is bad, because the economy is running out of capacity.
It is too early to be sure that “bad” inflation is on the way. Over 2018 as a whole stocks and benchmark 10-year Treasury yields still had a tendency to move together, and while formal measures of their correlation aren’t as strong as they were, they remain positive. We are nowhere near 1980s or even 1990s level of concern about inflation.
Still, Friday’s wage data and numerous company reports show that the tight jobs market is pushing up wages, while tariffs are being passed on. To protect against an acceleration in inflation, pick businesses with pricing power, whose brands, monopoly positions or must-have products make consumers willing to accept higher prices.
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