Stocks finished mixed Friday with the Dow up slightly while the NASDAQ suffered a modest decline as social media stocks fell sharply in the wake of Snap’s disappointing earnings. But, overall, it was a very strong week for stocks as earnings season got underway in earnest.
What we have learned so far, as we head into the biggest week for earnings, is that large, well-managed companies have been remarkably adept at dealing with all the supply chain issues. But they aren’t all immune to the difficulties. Those that relied heavily on imports had some problems. All incurred higher costs. Some were able to pass them through better than others. Overall, earnings once again are handily beating expectations, which is a testimony to both good management, and their ability to rein in excess analyst optimism. That’s a polite way to say that they manage expectations to limit any disappointments when they report.
There were some notable misses, however, including some tech names like IBM and Intel. Disappointing results are never well received during earning season. Among the stocks to watch this week are the social media companies and the Internet giants highly dependent on advertising. A change in Apple’s operating system for its iPhone was designed to protect privacy. It also made it difficult for Internet sites to collect quality data that allowed advertisers to home in on special customers. The lower quality data brought with it the likelihood of lower fees. That caused Snap to lose over 20% of its value on Friday. Facebook#, which has been battling its own political issues lately, reports tonight. It will be one of the most closely watched reports this week. Major media outlooks, like The Wall Street Journal and The New York Times, have been hammering Facebook lately. Unlike a newspaper that vets content before it is released, Facebook has little choice but to vet postings only after they appear. That vetting process cannot be bias-free. What is too sexual, too political, or fake news has a fuzzy dividing line. This is a debate Facebook and others are not likely to win in the political and media worlds. To be sure, Facebook at times is its own worst enemy. The economic reality is that advertisers are driven to sites with the best data and the biggest audiences. That means Facebook and Google. This saga has a long way to go. How social media changes and adapts will be determined in part by the legal process and in part by technology, and changes in personal tastes. For now, the traditional social media leaders remain the best in class and most effective advertising platforms.
Social media occupies a tiny fraction of the investment arena. While it has been a bumpy ride for some, as noted above, earnings season has gotten off to a pretty good start. The market has responded positively. Here are some important points:
1. The Delta variant is fading fast, at least in the U.S.
2. Supply chain problems are acute. There are signs that the worst may be over before the end of the year. It may take all of 2022 to clear most bottlenecks, but markets care about direction. Improvement going forward is good.
3. Inflation is real and, in many cases, getting worse. There are few signs commodity prices have peaked yet. Wages are just starting to take off. Rents have risen sharply. That hasn’t been reflected yet in CPI data, but it is only a matter of time. Transient inflation that was due to last a few months, now, according to Fed and Treasury officials, may last a year.
4. The consumer is more than willing to spend. If only the products he or she wants is still on store shelves in a month is a concern. For now, the answer may be yes, but the costs to keep stocked will climb.
5. Interest rates are beginning to creep up again. Longer rates are back near their March peaks. The trend is worldwide. The German 10-year yield threatens to turn positive for the first time in about 2 ½ years.
6. The amount of excess money sloshing around continues to climb. M2 is rising at about a 13% rate, far above growth rates for the economy. With banks and bonds paying near zero, investors are putting cash everywhere from bitcoin to vintage Air Jordan sneakers.
7. Congress is getting closer to a reconciliation bill, likely to be about half what progressives and the President first asked for. But, combined with the infrastructure bill waiting a House vote, it would still mean 3+ trillion in new spending over the next 10 years or roughly $10,000 added spending for every man, woman and child in the United States. Less certain is how Congress wants to pay for all of this. The newest proposal is a tax on unrealized gains for billionaires. Implementing that won’t be easy. One should always be leery of new proposals popped into legislation at the last minute. Often such proposals lead to unintended consequences. We will have more to say when we see the details. So far there are none.
For investors, by far the biggest question to be answered is the long-term expected inflation rate a year from now. In other words, how much of the inflation we see today is permanent or at least semi-permanent. Commodity prices always ebb and flow. One can argue that the mean price for a barrel of oil over the next five years will be higher than it has been for the last five years. But year-to-year changes are anyone’s guess. The same could be said for corn, beef, or copper. Clearly, as the world economies absorb most of the excess capacity left behind by the Financial Crisis of 2008-2009 and the Covid-19 pandemic, there will be some upward pressure on price. Perhaps the biggest shortages will be labor and rents. Higher wages can entice more people into the work force but there is no economic way to create more people. If the economy is growing 2-3% and population is growing by less than 1% per year, anyone can figure out that when it comes to wages, the power is shifting from employer to employee.
Look at mask mandates. United Airlines announced a few months ago a mask mandate for employees. Other airlines moved in that direction but when enough pilots and mechanics balked, forcing several to cancel hundreds of flights, several airlines reconsidered. The unvaccinated will have to be tested but there isn’t much urge to fire employees when already short staffed. Airlines are simply one example of many. I am not taking a stand on mandates. Rather, I am pointing out the economic consequences. Each employer and community will have to make their own choices.
To me, the bottom line is that core inflation expectations are rising, even recognizing that some of the inflation we see today is transitory and will reverse once supply chain problems are fixed. The simplest example to prove a point is used cars. Many now sell over sticker price because no comparable new cars are available. Once there are new car alternatives, no one will pay over sticker price for a used car.
The next question is how does inflation get translated into interest rates? Logic says the two should be highly correlated, but that isn’t always so. An additional factor is borrowing needs. Corporations are flush with cash. Government tax receipts are soaring, and the emergency pandemic-related funding is abating. Thus, demand for new funds may decline muting the impact on rates. One also needs to consider the spread between U.S. rates and those available around the world. Ours have been higher than the rest and likely will remain so. It’s the spread that matters, one we can’t predict with any precision.
Finally, one must ask what the future rate of growth will be. The simple answer is that government spending growth will slow for the next two years due to the sharp decline in pandemic support spending. On the other hand, the private sector growth will be above average as (1) the entire economy reopens, and (2) inventories are rebuilt as supply chain issues are resolved.
The bottom line is more growth and somewhat higher rates. If rates surprise to the upside, equity returns will be muted. If inflation rises but only marginally, 2022 will be another healthy year for equities.
One final point. Statements from Powell and Yellen acknowledging the stronger than expected inflationary pressures may actually be good news. Tapping the brakes (which could include a couple of Fed Funds rate increases) is much more preferable than falling behind and being forced to slam on the brakes to mute inflation. Powell and Yellen’s comments may be a bit late, but they are not too late. Markets are now pricing in a 75% chance of two rate increases in 2022. In August, those odds were 20%. Markets listen.
Today, Katy Perry is 37.
James M. Meyer, CFA 610-260-2220