While investors are celebrating the signs suggesting that U.S. inflation is slowing down, there are concerns that this trend may have a negative impact on company earnings and, in turn, weigh on stock prices. Companies are currently releasing their second-quarter financial results, and this comes as the Dow Jones Industrial Average is on pace to record its 12th straight day of advance.
According to Tom Essaye, president at the Sevens Report Research, “Stock prices are a combination of a multiple and earnings, and while disinflation may be good for the former, it could be negative for the latter.” When companies significantly raise prices, consumer demand usually evaporates, resulting in higher profit margins for companies but lower aggregate sales numbers.
However, in recent years, consumers have continued to buy despite high prices. This was due to high amounts of personal savings and low unemployment, coupled with a recovery from the repressed demand during the pandemic. Essaye highlights that “the result was great for corporate America – higher margins and higher sales. However, disinflation will pose a threat to that positive mix.”
As we enter the current earnings season, it is crucial to pay attention to commentary on pricing and consumer demand. As inflation falls, many companies’ margins and profits will also decrease. This presents a downside risk into earnings that is not currently priced into stocks.
According to Dow Jones market data, all three stock indexes are trading at levels close to their 15-month high. However, as inflation slows down, Eric Freedman, chief investment officer at U.S. Bank Wealth Management, points out that “earnings expectations that were perhaps predicated upon a higher and more consistent inflationary rate will also come down.”
Moreover, during periods of inflation, there is often a conflation of nominal mismatches between topline prices (CPI) and input costs (PPI) with sustainable improvement in profits margins. Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management, expresses this concern in a recent note.
In conclusion, while the slowing down of U.S. inflation may be seen as positive by investors, it can have a negative impact on company earnings and stock prices. This is a factor that needs to be closely monitored during the current earnings season, as it poses a downside risk that is not currently reflected in stock prices. Understanding the relationship between inflation, earnings, and stock prices is vital for successful investment decision-making.
CPI and PPI: Understanding the Metrics
Introduction
CPI and PPI are two essential metrics used to assess different aspects of the economy. The consumer price index (CPI) is utilized to calculate cost-of-living adjustments, while the producer price index (PPI) is mainly used to gauge real growth.
Reversion to Zero
Historically, the difference between CPI and PPI has been significant, but this divide rarely persists. Over time, the difference between these metrics tends to revert to zero. Interestingly, when prices paid indexes indicate plummeting prices, margins are often affected after a six-month lag.
Domestic vs. Multinational Companies
Domestic-oriented companies in the United States are likely to face increased pressure due to disinflation. On the other hand, multinational companies may experience a slowdown in economic growth in China and Europe. However, the disinflationary pressure is somewhat offset by a weakening dollar.
Inflation Deceleration
Although the rate of inflation is decelerating, prices continue to rise. While this signifies positive progress, it’s important to note that prices are still increasing and doing so at a faster rate than desired by the Federal Reserve.
Uncertainty Surrounding Interest Rates
While the market anticipates a 25 basis points increase in the Federal Reserve’s benchmark interest rate during their upcoming meeting, it remains uncertain if further rate hikes will follow. According to the CME FedWatch tool, traders are estimating a little over a 30% likelihood of an additional rate hike post-July.
Market Performance
On Tuesday, U.S. stocks demonstrated positive momentum. The Dow Jones Industrial Average (DJIA) rose by 0.3%, the S&P 500 increased by 0.4%, and the Nasdaq Composite experienced an 0.8% surge.
Conclusion
Understanding CPI and PPI is crucial in analyzing economic trends. While the market awaits the Federal Reserve’s decision on interest rates, the delicate balance between inflation and growth continues to shape the economic landscape.