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Thursday, June 8, 2023

5 reasons why Wall Street isn’t freaking out about inflation

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Americans are increasingly sour on the U.S. economy, with many of them pointing to the highest inflation in 30 years as cause for alarm. But Wall Street is shrugging off these concerns, as stocks are pushed higher and with the Dow Jones Industrial Index hitting a record 36,000 earlier this month.

About 65% of Americans now view the economy as poor, according to a poll by The Associated Press-NORC Center for Public Affairs Research. And both consumers and economists predict inflation will continue to rise over the next several months.

Given that everything from gasoline to food costs more — and is eating into household purchasing power — why isn’t Wall Street freaking out? It’s a question that is causing some people to scratch their heads, according to Anatole Kaletsky of Gavekal Research.

“Many investors and most economists seem baffled, or even angry, about how equities keep hitting new highs while bond yields remain remarkably stable in a narrow trading range of 1.25% to 1.75%,” Kaletsky said in a research note. “In my view, the most surprising thing about these market conditions is that they are described as surprising.”

Below are 5 reasons why investors — so far — are taking inflation in stride. 

Higher inflation won’t last forever

Sure, economists now believe that inflation will persist into 2022 and could even bump higher in the next few months. But the consensus is that price increases will stabilize at some point in 2022 as the supply chain issues resolve themselves and more Americans return to the job market, also easing supply constraints.

Inflation, which measures rising prices, started ticking up in April as the economy reopened and Americans, flush with cash from several rounds of stimulus aid, began buying again. Bottlenecks in the supply chain have caused shortages, pushing prices up amid a boost in consumer demand. But economists expect some of those issues to resolve themselves next year.

“Inflation will drop to the low 2s by late 2022 or early 2023, without an aggressive monetary policy response,” Goldman Sachs analysts noted in an October report. “The key reasons are that the level of fiscal support will continue to decline sharply and supply chain problems should be resolved, turning the inflationary surge in the goods sector into a temporary deflationary drag.”

Rising prices are good for companies

Higher prices, while painful for consumers, can actually be a good thing for corporations, noted Brad McMillan, chief investment officer for Commonwealth Financial Network, in a Thursday research note.

“If demand is strong, as it is right now, companies can raise prices — and sales — without hurting demand,” McMillan noted. “And that is what we are seeing.”

Corporate margins are rising

To be sure, higher inflation equates to higher costs for companies, but typical corporate expenses — like rent and wages — often rise at a slower rate than sales, which can result in higher corporate margins in an inflationary period, McMillan added.

Supply constraints are “good news for corporate earnings, whereby U.S. companies are able to maintain margins by passing on costs to consumers,” noted Christopher Vecchio, senior strategist at DailyFX, noting that he is keeping his year-end target of 4,800 for the S&P 500, which is now trading at about 4,700.

Indeed, profit margins for the S&P 500 in the third quarter reached 12.9%, above the 5-year average of 10.9%, according to FactSet. 

Inflation on a two-year basis isn’t that high

Some economists also point out that the current rate of inflation isn’t terribly high when looking at it over a two-year horizon. The pandemic led to a massive decline in demand for goods and services as consumers stayed home in 2020. 

The surge in prices in 2021 is partly “payback for the slump in inflation to 1.1% in the previous 12 months,” noted Kaletsky of Gavekal Research. “Taking the 24 months together, U.S. inflation, even including energy, has been running at an annualized 3.7%.”

“It is hardly the stuff of stagflation nightmares,” he added.

The economy is growing strongly

Real GDP growth is expected to jump to 5% in the fourth quarter, up from 2% in the third quarter, according to a forecast earlier this month from the Conference Board.

As the nation emerges from the surge of Delta cases, economic growth will rebound at the end of this year, Conference Board principal economist Erik Lundh said on a conference call earlier this month. Consumer demand is likely to remain strong given pent-up demand for goods and services, and as wages increase, economists say.

“The world economy is growing strongly, with no risks of recession in any important region, and with profits rising across almost all sectors,” Gavekal’s Kaletsky said. 

Reasons to worry?

To be sure, investors are still keeping their eyes on inflation and other economic headwinds. And economists have certainly been known to give inaccurate estimates — if inflation doesn’t subside in 2022, the risks for a greater economic impact could be higher. 

“The effects of a rise in interest rates could be material, especially in the short term,” noted McMillan. “This potential is worth paying attention to. Over time, though, companies are well positioned to act on, and benefit from, moderate levels of inflation.”

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