Stocks continued their rebound yesterday as earnings season began to get into high gear. The next 10 days will be the peak of earnings reports.
Yesterday was a bit educational. Two big Dow components, Johnson & Johnson# and Procter & Gamble# reported. J&J had really good results and raised guidance. It generally operates in business arenas that are isolated from the supply chain issues. That doesn’t mean they are non-existent, but the company was able to cope. Moreover, it has some price elasticity to offset rising costs. P&G, on the other hand, got caught. It tried to hold the line on prices as much as it could. After all, while its brand supremacy allows it to charge premium prices, soap, toothpaste, and diapers are pretty much commodities within very competitive markets. Granted, its competition sees the same input costs and freight rate problems P&G has, but the industry overall simply doesn’t have the pricing power that others have. J&J shares rose almost 3% on their earnings, while P&G’s stock fell more than 1%.
In the wake of the Great Recession and for most of the decade that followed, the world was awash in excess supply. That’s what happens after a huge financial crisis. Businesses close, people lose their jobs, and sellers must accept the prices buyers are willing to pay. Add the deflationary influence of the Internet on price discovery, and you have the setup for a long period of time where the scales tip in favor of the buyer. Economists have noted that it takes about a decade for the excesses to be reabsorbed. That decade took us to the cusp of the Covid-19 pandemic. A very quick recession set back normality for a year or so, but massive fiscal and monetary measures not only maintained demand, they fueled additional demand.
Economists have noted the absence of inflation for decades. But one could argue that inflation began to appear in earnest over the past decade. The inflation we saw was asset value inflation, not rising costs of what we buy every day. The Federal Reserve more than doubled the size of its balance sheet, pouring trillions into the market. Congress added trillions more. While some clearly was directed at people and businesses in real need, a lot went to entities that hardly needed the extra money at all. A front page story in today’s Wall Street Journal highlights the problems faced in California getting all the money into the right hands. You have all heard of Medicare fraud. Unemployment claim fraud could dwarf that once we know all the details. That’s one of the consequences of shoving too much money into the world too quickly.
Thus, now we live in a world where capacity utilization is back to normal. While some parts of that economic world remain oversupplied, others have no idle capacity. That, plus port delays around the world, are the cause of today’s supply-chain debacle. And despite Fed assertions that we still have millions of people unemployed during the pandemic to put back to work, any employer will tell you that hiring adequate quality workers today may be their biggest problem.
We have chronicled this many times in recent weeks. Some of the supply chain pressures will lessen with higher prices and concerted efforts to get containers unloaded and shipped from key ports around the world. Just as traffic unclogs after rush hour, some of the supply chain snarls will unwind in the months ahead. But even when there are no ships waiting offshore to unload and all those containers we see stacked up in California get delivered, there will still be supply/demand imbalances. In some cases, the pending surge in production will get so far ahead of demand that prices will tumble. We saw that this past summer with lumber. There never was any shortage of trees in the U.S, but there was a shortage of cut timber. The solution was obvious. Higher prices brought in more supply quickly. At the same time, surging demand for homes abated as prices skyrocketed. Lumber prices tumbled. As order was restored, housing demand picked up again and lumber prices started to rise once more, but the panic levels of last Spring are long gone. While the U.S. still needs more quality housing, supply/demand in housing markets has gotten back to more normal levels.
Today’s normal is different than yesterday’s. Pre-pandemic, you could list a home and wait months for a bid. Realtors told you to take the first respectable bid if you wanted to sell your home. That could take months. While the frenzy last Spring that saw long lines at open houses, and multiple bids above asking price in a matter of days, is over, today’s new listings are selling much quicker than two years ago. Some still sell above asking price but there is some bargaining as well. Sellers need to price right to get a sale done quickly. The final price will be 10-20% more than it was two years ago, but not 10-20% above where it was two months ago.
The housing market may be a roadmap of what is to come overall. Once relative calm is restored, we see that sellers no longer can command anything they want, but sellers are in much better shape than they were two years ago.
We all know that asset inflation has spilled over into inflation for consumer goods. We see it every day in the supermarket, at the gas pump, and almost everywhere we look. As with lumber, the sharp spikes will fade as supply returns and balance is restored. But with tight capacity and a shrunken employee pool, sellers are going to retain some of the pricing power they got as all the excesses of the Great Recession get absorbed, while at the same time, monetary and fiscal stimulus continue.
Judging underlying systemic inflation will be difficult. Surging used car prices caused a spike in inflation this Summer. They have since stopped going up. Inflation rates moderated, but the prices remain elevated. Inflation indices measure the month-to-month change in prices. If the price for something goes up 10% one month and drops 2% over the following two months, does that mean deflation has set in? Of course not. Prices are still up 8% in a short time. With that said, there will come a time soon when food prices and gasoline will fall back. It won’t just be commodities. If there are too many goods in stores, you will see more sales. Finding the new balance takes time. Therefore, we won’t know the core inflation rate for at least a year, probably longer, but we will know who has pricing power.
Microsoft recently introduced Office 2021 at a modestly higher price than Office 2019. Will new buyers pay the difference? No question. Office software costs are not top of the list concerns for any purchasing managers. In addition, the newer addition has added features. Microsoft has purchasing power. Does P&G? We’ll soon see. The company intends to raise prices to offset costs. The market will determine whether the increases stick.
As investors, we must judge company-by-company who has pricing power and who doesn’t. The cellular phone companies do not. They are locked in price wars to gain or retain customers in an emerging 5G world. Airlines are starting to get pricing power back, but their industry is always one of delicate supply/demand balance. Oil companies today have pricing power, but will they tomorrow? There is little question that today’s high prices will bring more production online. Will that achieve balance or oversupply? Look at your supermarket. How many boxes of cereal do you see? Can they all raise prices to offset rising costs? They can, but then consumers have the option of having toast and jam for breakfast instead of a bowl of cereal.
As investors, as we finally leave a world awash with excess capacity, there will be a shift in pricing power. Those that have it will maintain or increase margins. Those that don’t, have a tough road to travel. Companies that help to increase productivity will be in high demand. The trick of successful investing is to understand these seismic sea changes and adjust our portfolios appropriately. Look at what you own and ask for each stock whether you are well situated in a new world, where the seller may have more pricing power courtesy of less excess capacity, in a market that lacks adequate labor supply.
Today, Vice-President Kamala Harris is 57.
James M. Meyer, CFA 610-260-2220