Eye on the Markets - 2021

Inflation and Variants Effects on Markets

By Ketu Desai

While it might be hard to tell by the indices, the market has been dealing with a growth scare related to COVID variants. When the market has a growth scare, it goes back to large cap tech names, which have essentially become defensive bond-proxies for many investors. The large cap tech names held up the broader S&P and Nasdaq, but there was plenty of damage beneath the surface. Most of the stocks trade below their 50-day moving average. The broader Russell 2000 was down as much as 10 percent. Yields moved lower with the growth scare. They also moved lower because of short covering, Fed buying, foreign demand, and a lack of supply. The combination of the Treasury drawing down cash balances at the Fed and QE has resulted in $1.3 trillion less in debt that would otherwise need to be placed. I suspect as the year progresses, many of these dynamics will reverse, and yields will start moving back upwards. The elephant in the room is inflation. Despite many inflation readings at the highest levels in a very long time, the market is continuing to discount more transitory inflation.

There are certainly items, such as used cars and certain commodities, where the inflation most likely is transitory. However, more and more measures are showing prices at their highest levels in years, and some by wide margins. For instance, the ISM price index is at the highest level since 1979. The index registered a reading of 92.1 percent versus 52.7 percent as the breakeven line, nearly double the pre-pandemic levels. While earnings season has been fantastic, with nearly 90 percent of companies beating, inflation commentary on conference calls really sticks out. See below on some of the commentary:

PepsiCo: “We're seeing inflation in our business across many of our raw ingredients and some of our inputs in labor and freight and everything else. So, we operate in the same context. We feel quite comfortable or confident that through a combination of net revenue management initiatives and increased productivity, we can navigate this."

Fastenal: “Price actions to-date have largely matched cost increases. There's a ton of inflation going on. There's inflation because of disruption and shipping.

“The marketplace is still receptive to price actions and the tools and processes we have developed have been effective. Even so, given the rate of inflation, maintaining price cost parity will be a bigger challenge in the third quarter."

Conagra: “We expect the negative impact of the cost inflation to hit our financials before the beneficial impact of our responsive actions, including our pricing. This timing mismatch is expected to be particularly impactful in (fiscal) H1 and, more specifically, in (fiscal) Q1. The resulting pressure on our first half margins impact our full year profit […] Although the substantial increase in inflation over the last few months has negatively impacted our profit guidance for the (fiscal) year, we remain confident in the underlying strength of the business...

“When we initially gave our fiscal 2022 targets at our Investor Day in April of 2019, our models assumed an annual inflation rate of around 3%. At the time of our third quarter call, in April of 2021, we expected fiscal 2022 inflation to come in at twice that level around 6% […] We now currently expect fiscal 2022 inflation to come in around 9%."

McCormick: “We're seeing broad-based inflation across our various commodities, packaging materials and transportation costs. To offset rising costs, we are raising prices where appropriate, but usually there is a lag time associated with pricing, particularly with how quickly costs are escalating. And therefore, most of our actions won't go into effect until late 2021."

PPG: “What we're obviously studying now is the need to be out with a third set of price increases. Inflation is across-the-board, it's obvious and customers don't have a lot of good ways to counter the argument that we need to have price relief.

This inflation cycle is much higher than anyone anticipated and we're continuing on a business-by-business basis, working to secure further selling price increases"

Most of this commentary barely hits on wage inflation, which is likely to come in the coming quarters, and should drive the next leg of the inflation story.

If the backdrop shifts in the coming months to higher yields and a sentiment shift to more persistent inflation, the value and cyclical trade will be back, perhaps in a major way. This includes areas such as energy, financials, materials, industrials, and consumer discretionary. Most of the value and cyclical stocks are down anywhere from 10-30 percent

in recent weeks. One area that looks particularly beat-up and interesting is names related to travel. Most measures of travel are near or above pre-pandemic levels, but many of the individual stocks are off 10-40 percent from their highs this year, and up to 50 percent off their pre-pandemic levels. JPM said on its earnings call during the month that looking across its card purchases, travel spending was up 13 percent versus June 2019. Bank of America reported similar results. Visa said on its call it saw, “a significant acceleration in travel, entertainment and restaurant spending as well as a resurgence of affluent cardholder spending." TSA throughput data is now around 2mm on almost a daily basis. Vehicle miles traveled is just slightly below 2019 levels. Even certain airlines are back to profitability. Many of these travel companies have said that bookings for 2022 are greater than 2019. Not only will this lead to revenue growth, but also margin expansion as they have spent the better part of the last year cutting costs. The PEJ (Travel ETF) trades at just 9.2x cash flow, with some even better bargains and upside if you're willing to invest in the single names.

Looking forward, the market will continue to focus on COVID trends, earnings, economic data, and the Fed's Jackson Hole meeting.


Ketu Desai is the Principal of i-squared Wealth Management Inc. ( www.isquaredwealth.com ), an investment management firm based in New Jersey. ketu@isquaredwealth.com