STAGFLATION ERODES MARGINS AND DEPRESSES MULTIPLES

It appears that every manufacturer survey out of late indicate more downward pressure on profit margins as producers are still having some difficulty passing “inflation costs” thru the supply chain. 

As a result, we continue to believe that EPS expectations embedded in S&P 500 (which is a lagging indicator) are too high; inflation slows growth, raises the cost of goods sold and lowers margins.  The resulting stagflation implies a lower multiple for the S&P 500.  As the chart below shows, expectations are past all-time highs in terms of EPS forward twelve-month earnings and actual earnings are also at peak levels.  While expectations are pressing higher and higher (the red line below shows the Street’s expectations roaring higher and higher), actual earnings have been lagging higher but – as I stressed earlier – earnings are cyclical lagging indicators.  They were in early 2009 when Hedgeye’s market-view was bullish and they remain so today.  Inflation, and its impact on earnings, cost of sales, and multiples, is the factor to watch at this juncture. 

STAGFLATION ERODES MARGINS AND DEPRESSES MULTIPLES - SPX Estimate vs Actual

The evidence of this was made clear in today’s Empire Manufacturing Index.  The report showed that prices paid (highest level since mid-2008 and the second highest ever) for inputs rose by a “median 5%” over the past 12 months, with manufacturers only planning to raise their own prices by a “median 4%.”  And that’s assuming they can get away with it!

STAGFLATION ERODES MARGINS AND DEPRESSES MULTIPLES - empire prices paid

As the economic recovery has progressed, and the easy-money policy in Washington has been unrelenting, the rise of cost pressures has been inevitable and manufacturers are feeling that pressure in the supply chain.  This time around it is occurring at a time when consumer confidence is stagnating and improvements in the labor markets are slowing.  Further complicating things is the inventories index which climbed to 10.8, its highest level in a year.   

On the positive side, the survey revealed that managers were more upbeat about the future and the hiring index climbed to the second-highest level on record.  This consistent with a number of consumer confidence readings we see that points to “future expectations” being well ahead of the reality of the “current conditions.”  However, expectations have been outstripping current conditions for some time now. 

Howard Penney

Managing Director