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By Trevor Hunnicutt
Oct 26 (Reuters) - U.S. quarterly earnings reports this month were supposed to give investors clarity about the health of Wall Street’s rally this year.
Instead, profit reports and forecasts following the most recent three months are giving investors indigestion as companies send unclear messages about the rising cost of goods and labor.
“I don’t understand why people are so hesitant to admit that we’re in an upturn in inflation,” said Richard Bernstein, chief executive of Richard Bernstein Advisors LLC.
Companies, he said, are “scared that they’re not going to get rewarded for pricing growth.”
The unexplained absence of inflation during the last decade’s U.S. equity price boom is now being replaced in investor psychology by fears that inflation is finally pushing up costs and squeezing margins and may be one of the culprits in this month’s selloff of U.S. stocks.
U.S. consumer price inflation was 2.3 percent in the year to September, according to the Labor Department, and even “core” inflation, which strips out volatile food and energy prices, is running at 2.2 percent for the year, above the Federal Reserve’s target.
With unemployment at 3.7 percent, the lowest in nearly 40 years, annual wage growth was 2.9 percent in September, a nine-year high.
The question is whether the cost increases companies say they are now absorbing are fleeting or here to stay.
At stake is a market rally built on the premise that stock valuations are justified by earnings that go on growing.
While earnings growth is still high at 22 percent so far this quarter, the amount by which S&P 500 index companies are beating analyst estimates is nearly half of what it was during the first quarter, according to Refinitiv data.
Unless companies can raise prices fast enough to keep up with the rising costs of hiring and materials, stocks may struggle to maintain current valuations.
Borrowing costs are also rising as the Federal Reserve is expected to keep raising interest rates into 2019 to ward off the inflationary threat, with U.S. economy growing at 4.2 percent in the second quarter this year, helped by last year’s $1.5 trillion worth of tax cuts.
And now U.S. businesses are also warning of input costs rising as a result of President Trump’s imposition of import tariffs. Steel and aluminum tariffs have cost Ford Motor Co about $1 billion in profits, its chief executive officer said last month.
“Market participants are really concerned that maybe finally we have seen peak earnings and that people are talking much more about costs rising and, looking ahead, corporate profit margins could certainly come under pressure,” said Fritz Folts, chief investment strategist at 3EDGE Asset Management LP.
Corporate leaders sit on the frontline of inflation, but they are not offering consistent guidance about where they expect the trend to go from here. The divergence in guidance and outlooks is costing investors money.
On October 8, paint-maker PPG Industries Inc told investors to expect lower profits, saying that it expected the prices for the raw materials it uses to keep rising, and its stock fell 10 percent during the following trading session. Economist Ed Yardeni said the forecast help set the stage for the broader market selloff later that week.
Yet PPG’s rival, Akzo Nobel NV, said nine days later that it thinks inflation on those sorts of items has peaked for the year. Akzo shares rallied 3.0 percent.
“There’s anecdotes about inflation pressures, but when you add them up we’re not seeing it in the macro indicators,” said Yardeni.
The Fed’s own “Beige Book” collection of anecdotal evidence on business conditions, published on Wednesday, said inflation has appeared modest or moderate in most parts of the country.
Investors are rewarding companies that can keep up with inflation and punishing those that cannot.
So far this year, companies with high operating leverage, typically meaning they can generate additional profits with relatively small increases in their costs, have returned 13 percent, including dividends, according to Goldman Sachs Group Inc data.
By comparison the S&P 500 has returned about 0.9 percent.
And anecdotes about costs abound.
At Del Taco Restaurants Inc, executives warned on an earnings call earlier this month that food inflation will increase in 2019 and its labor costs will grow too, given an increase in California’s minimum wage, despite efforts to minimize labor by using food processing machines to cut more cheese and tomatoes. The company hopes to offset those at least some of those increases by raising prices. Del Taco shares fell to a more than 2-year low.
But inflation has helped other companies.
Nestle and Unilever , two of the world’s biggest consumer goods makers, both reported a pick-up in sales last week as inflation helped give them greater scope to push through price hikes. Both companies’ shares rose on the news.
While inflation has risen and is a concern, markets generally see it contained. One bond-based measure of consumer inflation expected over the five years starting in 2023, puts the figure at 2.2 percent, little changed from today.
But some equity investors are not waiting for a clearer signal. Bernstein, for one, said he is investing with an emphasis on sectors, primarily in cyclical consumer industries, that can pass on costs to their customers.
“You need companies that have pricing power,” he said. (Reporting by Trevor Hunnicutt in Washington; editing by Jennifer Ablan and Clive McKeef)